The yield curve, also called the term structure of interest rates, is a graph that plots the yields of similar-quality bonds against their maturities, ranging from shortest to longest on the horizontal axis.
Professional stock traders and investors use the shape of the yield curve to predict both Bull and Bear market cycles.
Normal Yield Curve
A normal yield curve, as pictured on January 22, 2016 above, means that yields rise as maturity lengthens. A normal yield curve reflects investor expectations for the economy to grow in the future and for this growth to be associated with a greater expectation that inflation will rise in the future too. This expectation of higher inflation leads to expectations that the central bank will tighten monetary policy by raising short-term interest rates in the future to slow economic growth and dampen inflationary pressure. It also creates a need for a risk premium associated with the uncertainty about the future rate of inflation and the risk this poses to the future value of cash flows. Investors price these risks into the yield curve by demanding higher yields for maturities further into the future.
Flat Yield Curve
A flat yield curve, as pictured on May 16, 2007 above, means that all maturities have similar yields. A flat curve sends signals of uncertainty in the economy. This mixed signal can revert to a normal curve or could later result into an inverted curve.
Inverted Yield Curve
An inverted yield curve, as pictured on August 7, 2000 above, occurs when long-term yields fall below short-term yields. An inverted yield curve occurs when long-term investors are willing to settle for lower yields now because they think the economy will slow or even decline in the future. The New York Federal Reserve regards an inverted yield curve as a valuable tool for predicting recessions two to six quarters ahead. An inverted yield curves also suggests that the market believes inflation will remain low.
On January 16, 2016, I published this video about the impact of the first Fed rate hike on the yield curve:
In October of 2010, I published a video on YouTube called Bonds and Quantitative Easing For Dummies where I explain what the Federal Reserve was doing with QE. This video has over +68,000 views to date:<< Back to Glossary Index