The yield curve is an illustration plotted on a graph that shows the yields on bonds of varying maturities, typically from three months to 30 years. Short-term bonds are known to offer lower yields, while long-term bonds typically offer higher yields. As a result, the shape of a yield curve—where the Y-axis shows rising interest rates and the X-axis shows increasing time durations—is a line beginning on the lower left side and rising to the upper right side. This curved line is referred to as a normal yield curve.
Factors That Influence the Yield Curve
Keeping in mind that bond prices and yields move in opposite directions, different factors influence movements on either end of the yield curve. Short-term interest rates, which are sometimes referred to as the "short end" of the yield curve, tend to be influenced by expectations for the U.S. Federal Reserve policy. These short-term rates often rise when the Federal Reserve is expected to raise interest rates and fall when it's expected to cut rates.
Long-term bonds, or the "long end” of the curve, are also influenced to some extent by the outlook for Federal Reserve policy, but other factors play a role in moving long-term yields either up or down—including the outlook for inflation, economic growth, supply-and-demand, and investors’ general attitude toward risk.
Generally, slower growth, low inflation, and depressed risk appetites help the price performance of long-term bonds and cause yields to fall. Conversely, faster growth, higher inflation, and elevated risk appetites hurt performance and cause yields to rise. All these factors push and pull simultaneously to influence the direction of long-term bonds.
Shapes of the Yield Curve
The yield curve is always changing based on shifts in general market conditions. It can steepen because long-term rates are rising faster than short-term rates, indicating underperformance for long-term bonds versus short-term issues. Conversely, the yield curve can flatten, which means that short-term rates are rising faster than long-term rates, indicating outperformance for long-term bonds relative to short-term issues.
Very rarely, the yield curve can be inverted. This occurs when short-term bonds are yielding more than long-term issues, or when the curve trends down and to the right rather than upward. An inverted yield curve usually occurs when investors expect an environment of sharply slowing economic growth, low inflation, and future interest rate cuts by the Federal Reserve.