yield curve

A yield curve is typically upward sloping; as the time to maturity increases, so does the associated interest rate. The reason for that is that debt issued for a longer term generally carries greater risk because of the greater likelihood of inflation or default in the long run. Therefore, investors (debt holders) usually require a higher rate of return (a higher interest rate) for longer-term debt.

An inverted yield curve, which slopes downward, occurs when long-term interest rates fall below short-term interest rates. In that unusual situation, long-term investors are willing to settle for lower yields, possibly because they believe the economic outlook is bleak (as in the case of an imminent recession).

Although a yield curve is usually plotted as a continuous curve, data for all possible maturity dates of a given debt instrument are usually not available. That means that several data points on the curve are calculated and plotted by interpolation from known maturity dates.

One of the most closely watched yield curves—often called “the” yield curve—is that of U.S. treasury securities (see also treasury note), issued by the U.S. Department of the Treasury. It shows the interest paid to holders of treasury securities across various maturities, and it serves as an indicator of the borrowing costs of the U.S. government. It is typically upward sloping, indicating that the government’s borrowing costs increase when it sells debt contracts with longer maturity times.

In the United States it has been observed that the treasury yield curve becomes inverted just before the economy enters a recession. That correlation suggests that the shape of the yield curve can be used as a predictor of U.S. recessions. For that reason, the Conference Board, an international nongovernmental organization (NGO) that publishes key economic indicators for world economies, includes the interest-rate difference between 10-year treasury bonds and the federal funds rate—the interest rate at which depository institutions lend reserve balances (federal funds) to each other—in its Leading Economic Index, which is used to predict the business cycles of the U.S. economy. That interest-rate difference (also called the spread) is essentially a measure of the shape of the yield curve, as it represents the difference between a long-term interest rate (the 10-year treasury bond) and a short-term rate (the federal funds rate). If the spread is negative, the yield curve is inverted, which might be an indicator of an imminent U.S. recession.