What is Yield curve?

The yield curve is a line on a chart that shows the interest rates on bonds from the same borrower but with different lengths of time. A bond is a loan to a government or company that pays regular interest. Its yield is the annual return if it is held to the end, and its maturity is how long until the money comes back. The most watched curve uses US Treasuries, the bonds of the US government, from a few months out to 30 years.

The curve can take a few shapes. Normally it slopes upward. Lenders ask for more interest to tie up money for ten years than for one, because more can change over a longer stretch, including inflation, the general rise in prices. A flat curve means short and long yields are about the same. An inverted curve slopes down, with short-term bonds paying more than long-term ones. Short yields closely follow the central bank's policy rate. Long yields reflect what investors expect about growth, inflation and future rates.

Here is a hypothetical example. Say a 2-year Treasury yields 3% and a 10-year Treasury yields 4.5%. The spread, the gap between them, is 4.5% minus 3%, or 1.5 percentage points, so the curve slopes upward. Put $10,000 in each, and the 2-year pays $10,000 × 3% = $300 a year, while the 10-year pays $10,000 × 4.5% = $450. That is an extra $150 for lending longer. Now suppose the 2-year yields 5% and the 10-year yields 4%. The spread is 4% minus 5%, or −1 percentage point. The curve is inverted, and the shorter loan pays $100 a year more.

A common misunderstanding is that an inverted curve is a countdown to recession, a broad decline in economic activity. Many economists treat inversion as a warning sign, but it is not a timetable. The delay before any slowdown is not fixed, signals can prove false, and stock markets do not move in step with the curve. Central bank bond buying, known as quantitative easing, can also push long yields down and blur the message.

For a private investor, the yield curve mainly helps make sense of bonds. It shows how much extra income comes with lending for longer, and that extra income comes with more sensitivity to rising rates. In 2022, US inflation reached about 9% and long-term Treasuries lost about 30%. That episode is a reminder that a higher yield on long bonds carries real risk. Reading the curve gives context for choosing between cash, short bonds and long bonds, rather than a signal for timing the market.

By Dr. Harry Hamann

What does an inverted yield curve mean?
It means short-term bonds yield more than long-term ones. This often reflects expectations that interest rates and growth may fall. Many economists watch it as a possible recession warning, but it is not a reliable timetable, and the lag before any slowdown varies.

Which yield curve do people usually mean?
Usually the US Treasury curve. A popular summary is the spread between the 10-year and 2-year yields, or between the 10-year and 3-month yields. A negative spread means the curve is inverted.

Who controls the yield curve?
No one fully controls it. The central bank sets short-term policy rates, which anchor the short end. Trading in the bond market sets long-term yields, reflecting expectations for inflation, growth and future rates. Bond buying by central banks can also influence them.