All About the Yield Curve

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The yield curve is a picture plotted on a graph that shows the yields on bonds of varying maturities, often from three months to 30 years. Short-term bonds are known to offer lower yields. Long-term bonds tend to offer higher yields. 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 that starts on the lower left side and rises to the upper right side. This curved line is referred to as a normal yield curve.

Factors That Affect the Yield Curve

Bond prices and yields move in opposite directions. Certain factors affect movements on either end of the yield curve. Short-term interest rates are sometimes referred to as the "short end" of the yield curve. They tend to be influenced by expectations for the U.S. Federal Reserve policy. These short-term rates often rise when the Federal Reserve is about to raise interest rates. They fall when it's on the verge of cutting rates.

Long-term bonds, or the "long end” of the curve, are also affected 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 as well. They include the outlook for inflation, economic growth, supply and demand, and your attitude as an investor toward risk.

Slower growth, low inflation, and depressed risk appetites often help the price performance of long-term bonds. They cause yields to fall. Faster growth, higher inflation, and elevated risk appetites hurt performance. They cause yields to rise.

All these factors push and pull at the same time to affect the direction of long-term bonds.​

Shapes of the Yield Curve

The yield curve is always changing based on shifts in the market. It can steepen when long-term rates rise faster than short-term rates. This predicts underperformance for long-term bonds versus short-term issues. The yield curve can flatten. This means that short-term rates are rising faster than long-term rates. This predicts outperformance for long-term bonds relative to short-term issues. 

The yield curve can be inverted, although this doesn't happen very often. It 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 often occurs when you and other investors expect an environment of sharply slowing economic growth, low inflation, and interest rate cuts by the Federal Reserve.