This article explains how the position and shape of the yield curve reveals much about the state of the economy.
The yield curve reveals how the bond yield changes along with the change in bond maturity. It is also called the term structure of the interest rate.
Because the yield curve reflects the relationship between bond yield and bond maturity, it is calculated based on bonds that are similar in other characteristics apart from maturities. Treasury bonds are very similar, and are therefore taken as the most suitable bonds to construct the benchmark yield curve.
To see what information is provided by the yield curve, we can consider the shape of the curve and the position of the curve.
As you have already seen, we can use the yield curve to monitor the performance of the economy in general. For example, we might observe that short-term interest rates are higher than longer-term rates. In effect, markets are predicting that in the future, short-term interest rates will be lower than they are now. If this is the case, then we will observe a downward-sloping yield curve, which implies a possible recession in the near future. Alternatively, if the yield curve indicates that the short-term interest rate is lower than longer term rates, then it is likely that in the future, shorter term rates will be higher than they are now. If this is the case, then we will observe an upward-sloping yield curve, which could imply the economy is recovering from a recession.
The yield curve also provides a picture of inflation expectations. If the government is currently pursuing a loose monetary policy to support the economy, short-term interest rates will be relatively low. However, this policy may stimulate higher inflation. Long-term investors will require higher bond yields as compensation for the higher expected inflation, and the yield curve will slope up.
You might ask if the government can affect the shape of the yield curve. Suppose the central bank would like to encourage more long-term investment. They can purchase long-term bonds, this increases the bond price, and reduces the yield. The yield curve will become flatter.
What can we learn from the position of the yield curve?
We can obtain information about the level of risk involved in bonds by comparing two yield curves. For example, if the yield curve of the Greek government treasury bonds is located above the yield curve of the UK government bonds, then for the same maturity, the Greek government should pay more to borrow than the UK government. This would suggest that the Greek government bonds are riskier due to economic stagnation, and a fiscal and financial crisis. This difference in yield between the two government bonds is called the yield spread (or risk spread).
Similarly, we can also estimate the yield spread for a corporate bond compared to government bonds. Because corporate bonds are in general riskier than government bonds, firms need to pay a risk premium when borrowing.
Finally, investors can derive information from the yield curve to guide their own financial decisions. For example, based on the yield curve, one can derive short-term interest rates, and forecasts of future short-term interest rates. Many personal finance decisions such as mortgages, car loans, etc, all depend on the forecasted changes in interest rates.
Can you see what the potential problems are when interpreting the yield curve? Share your thoughts in the comments.