Updated August 2018
The yield curve describes the differences in interest rates between government bonds of varying durations. It provides an overview of the market’s outlook for interest rates, a key consideration for both bond and equity investors.
Everything else being equal, bonds with longer durations should have higher interest rates because the investor has to wait longer before they mature and there is a greater threat of inflation eroding the bond’s value. So ten-year US Treasuries should yield more than those with a three-month maturity. The relationship between the two will also depend on expectations about future interest rates. So if people expect interest rates to rise rapidly in the future, the yield curve will be steeper than if everyone thinks that rates will remain the same.
Occasionally the yield curve become inverted, with longer-term bonds yielding less than short-term bonds. The lower future interest rates implied by this pattern should be good news for indebted companies, which would pay less interest. But since they suggest that the central bank will choose to cut rates in future, the inverted curve is interpreted as a harbinger of economic weakness.
Some traders argue that since the bond market anticipates economic news better than the stockmarket, an inverse yield curve is a
strong sell signal for stocks. Ben Carlson of Ritholtz Wealth Management has found that, every time since 1970 when ten-year US Treasury bonds fell below those of two-year bonds, a recession was imminent.
• Watch Tim Bennett’s video tutorial: Beginner’s guide to investing: the yield curve.