What is the Yield Curve?

Yield Curves for Bond Performance Help You Understand Other Economic Factors

Needles in curve
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Bond Investors will sometimes hear the term “yield curve.” What is a yield curve and how can understanding yield curves improve your bond investment results?

The Yield Curve: Definition and Explanation 

The yield curve is a graphic illustration of the yields on bonds of varying maturities -- typically from three months to 30 years -- plotted on a graph.

Short-term bonds most often offer lower yields, while longer-term bonds offer higher yields.

As a result, the typical shape of a yield curve, where the Y-axis shows rising interest rates and the X-axis represents increasing time durations, is a line that begins on the lower left and rises to the upper right, as illustrated in the accompanying image showing the ​U.S. Treasury yield curve from May 22, 2013. This curved line is referred to as a “normal” yield curve

Each country has its own yield curve, as does each segment of the market.

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 -- also called “the short end of the yield curve”-- tend to be influenced by expectations for U.S. Federal Reserve policy. Short-term rates tend to rise when the Fed is expected to raise interest rates, and fall when it is expected to cut rates.

Longer-term bonds --the “long end” of the curve -- are also influenced to some extent by the outlook for Fed policy, but other factors play a role in moving long-term yields up or down. Foremost among these are the outlook for inflation, economic growth, supply-and-demand factors, and investors’ general attitude toward risk.

Very generally speaking, slower growth, low inflation, and depressed risk appetites will help the price performance of longer-term bonds (and cause yields to fall). Faster growth, higher inflation, and elevated risk appetites will hurt performance (and cause yields to rise). All of these factors push and pull simultaneously to influence the direction of longer-term bonds.

Shapes of the Yield Curve

The yield is always changing based on shifts in general market conditions. It can steepen, which means that long-term rates are rising faster than short-term rates (indicating underperformance for longer-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 (which indicates outperformance for longer-term bonds relative to short-term issues). 

Very rarely, the yield curve can also become “inverted.” This occurs when short-term bonds are actually yielding more than longer-term issues, meaning that 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.