Yield Curve
For bonds of the same credit quality, the Yield Curve is a graphical representation of yields versus maturities. As shown by the example below, with a normal yield curve, yields rise as maturities lengthen. In other words, long-term bonds typically have higher yields than short-term bonds have. During normal circumstances, lenders will demand higher yields the longer the lending period. Essentially, lenders want to be compensated for the increased Duration Risk that they assume with longer-term bonds.
However, if interest rates are expected to decrease, the curve becomes inverted, meaning long-term bonds have lower yields than short-term bonds have. This is known as an inverted or negative yield curve. Lastly, a flat yield curve is one in which short, intermediate, and long-term bonds have substantially similar yields.
The Yield Curve is used to predict changes in economic output and growth. A normal yield curve can indicate inflation, a flat one can forecast an economic transition, and an inverted one can indicate a recession. Historically, inversions of the curve have preceded many of the U.S. recessions. Due to this historical correlation, the curve is often seen as an accurate forecast of the turning points of the business cycle.
