Yield curve

A yield curve is a graph that shows how the yields on a group of related bonds vary according to their maturity. Investors normally focus on the yield curve for bonds such as US Treasuries or UK gilts. These governments have a vast number of outstanding bonds, with remaining maturities ranging from months to many decades in the future, so their bonds provide a key benchmark for pricing other bonds and loans of different maturities. However, yield curves are also used to compare yields versus maturities for bonds issued by a group of borrowers that have similar credit ratings, or even a single large company.

Yield curves move up and down, and shift in shape, in response to demand for bonds of different maturities. A normal yield curve slopes up from left to right – ie, longer-dated bonds yield more than shorter-term ones. That’s because investors expect to be compensated for risks such as inflation or default over the period of the loan, and uncertainty about these risks increases with longer-maturity loans. Hence they demand higher yields to lend for longer to reflect this uncertainty.

If the yield curve starts to flatten – the gap (or spread) between yields on short-term bonds and long-term ones narrows – then it may suggest that investors think inflation will fall, so they don’t need as high a yield from longer-term bonds to compensate for inflation risk. Alternatively, it may imply that interest rates are set to rise in the short term, but will stop rising further as growth slows.

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A flat yield curve may give way to an inverted one. This means investors expect short-term interest rates in the future to be lower than they are today, so they are happy to lock in today’s yields on longer-term bonds. That in turn suggests they expect inflation to fall enough that the central bank can cut interest rates – or the economy to slow so much that it will be forced to cut in the hope of boosting demand and renewing growth.