What is the yield curve?

We know that when investing in a long term bond, the investor should get a higher rate of return on his investment. A longer investment period implies more uncertainty in the investment. So the investor will want a higher rate of return. Therefore, bond yields change with bond maturities. And we can see that relationship represented by the yield curve. In this video we will examine what the shape of the yield curve can tell us about the economy. The yield curve can take three different shapes. Let’s first look at the normal yield curve, which is shown by the first graphic here. It is a normal yield curve because the curve is upward sloped, which suggests that bonds with longer maturities generate higher yields.

According to this type of yield curve, at the moment the short term interest rate is low, there is a tendency to increase the interest rate in the future, which a benchmarked by the government bond yields. From an economic point of view, if the interest rate is expected to increase in the future, then it mirrors the situation where the economy is getting stronger in the future. This implies that the current economy is recovering from a recession along the business cycle. What if the yield curve is downward sloped? In contrast to the upward sloped yield curve, a downward sloped yield curve implies that the current interest rate is too high. So the interest rate in the future will be lower.

This is consistent with an economy that is facing a recession in the near future. Some economists claim that they correctly predicted the 2007 and 2008 global financial crises by judging the shape of the yield curve before the crisis. Finally, the yield curve can also take a flat shape, shown here. Obviously, this type of yield curve suggests that the interest rate will not change in the future, which implies that there is not much economic activity in the economy. We should say this type of yield curve is not often seen in reality.