What is Yield Curve?
A graph plotting time (from shortest to longest maturity date) on the horizontal access, and yield on the vertical access is termed as “yield curve”. It shows yield and maturity relationship.
Followings are the types of yield curves
If a bond is with longer maturity it pays a higher yield as compared to that of shorter maturity. The yield curve sloping upwards is normal.
Investors demand high rate of return when they buy longer term bonds because they expect interest rates to rise in future. But when longer term bonds does not pay more interest, investors in that case would prefer buying short term bonds and they expect that they will obtain high return on next purchase when the bonds mature. Expectations for future interest rates increase when economy comes out of recession. It happens because normally, economic recoveries and borrowing for investment are accompanied, it increases demand for money and results in putting upward pressure on interest rates.
When all yield maturities are close to one another the curve becomes flat yield curve. There is a point where inflation expectation decreases to an extent when there is no demand of premium from investors for tying up their money for longer time. Same as inverted yield curve, yield curve moving from normal to flat result in pending or ongoing economic slowdown.
When short term and long term rates are closer to each other rather than being with medium term rates, yield curve is humped. This happens when there is;
- Increase in demand
- Shortage and decrease in supply of longer term bonds
In recent years, there has been a larger increase in demand for 30 year treasury bonds for example, than for 20 year treasury bonds, causing the yield curve for treasuries to often form a humped shape.
Lower longer term rates than that of shorter term interest rates result in inverted yield curve. This rarely happens, but whenever happens it surely is sign of ongoing economic slowdown.