What it means
Each point on the curve is the yield an investor earns for lending to the government for that length of time. Normally longer loans pay more, because tying money up for a decade carries more risk of inflation and rate changes than lending for three months.
That upward slope is the usual state of affairs. The curve matters far outside bond markets because it prices almost everything else.
Mortgage rates, corporate loan pricing, lease rates and the discount rates used in company valuations are all built on top of government yields for a similar term, so a shift in the curve moves the cost of capital everywhere. An inverted curve, where short rates sit above long rates, means investors expect rates to fall, which usually implies they expect the central bank to be cutting because growth is weakening.
Inversions have preceded most recent recessions in developed markets, though the lag has varied widely and inversion is a signal rather than a certainty. Analysts summarise the curve with a single spread, most often the ten year yield minus the two year, and watch whether it is steepening or flattening.
Steepening usually accompanies expectations of stronger growth or higher inflation, while flattening suggests the opposite. The curve also contains implied forward rates, which are the future short term rates the market is effectively pricing in today.
These are useful for testing whether a business's own interest rate assumptions match what the market believes, rather than what the finance team hopes.
In practice
Real-world examples.
Example
A treasurer refinancing a $20,000,000 facility sees a steeply upward sloping curve and chooses a three year fixed rate rather than ten years, judging the extra 90 basis points for the longer term too expensive for a business that may repay early.
Example
A pension fund manager watches the curve invert and shifts part of the portfolio from short dated deposits into longer bonds, locking in today's yields before the expected rate cuts arrive.
Example
A retail bank sees the gap between two year and ten year yields narrow sharply. Because it borrows short from depositors and lends long through mortgages, that flattening squeezes its interest margin and it responds by repricing its savings accounts.
Think of it
“Yield curve shows rates across maturities-the shape of interest rates over time.
Formula
Calculation
Term spread = long term yield - short term yield. Implied forward rate for one year, starting one year from now = [(1 + two year yield)^2 / (1 + one year yield)] - 1.
Suppose the two year government yield is 4.50% and the one year yield is 4.00%. The implied one year rate starting twelve months from now = (1.045 x 1.045) / 1.04 - 1 = 1.092025 / 1.04 - 1 = 1.0500 - 1 = 5.00%. In other words, the market is pricing roughly a full percentage point of rate rises over the coming year, since the one year rate of 4.00% today is expected to be 5.00% twelve months from now.
Now take a different day when the ten year yield is 4.20% and the two year yield is 4.80%. The term spread = 4.20% - 4.80% = -0.60 percentage points, an inverted curve, telling you the market expects short term rates to be lower in a few years than they are today.Case study
Seen in the real world.
This is an illustrative and fictional scenario. Ridgeway Components, an invented manufacturer, was preparing a five year plan and its finance director assumed borrowing costs would stay at the current 5% throughout, simply because that was the rate the company was paying at the time.
An analyst on the team plotted the government curve and noted that it was inverted, with two year yields well above ten year yields, implying the market expected meaningful rate cuts. Rebuilding the plan on market implied rates rather than a flat assumption lowered forecast interest costs by about $1,400,000 over five years and changed the answer on a marginal factory investment from reject to approve.
The fictional board did not treat the curve as a forecast, since the market is often wrong. What it did do was run the plan under three scenarios, rates as implied by the curve, rates flat and rates a point higher, and choose an investment that worked in all three.
Watch out
Common mistakes.
- Treating an inverted curve as a precise recession timer, when the lag between inversion and any downturn has historically ranged from months to well over a year.
- Assuming today's borrowing rate will hold for the life of a five year plan instead of testing the plan against the rates the curve implies.
- Comparing yields across different countries or credit qualities as though they sat on the same curve, which mixes currency and default risk into what should be a pure term comparison.
Questions
People also ask.
Which yield curve should a business look at?
Normally the government curve for the currency it borrows in, because corporate rates are quoted as a spread above those benchmark yields.
Does a steep curve always mean strong growth is coming?
Not always, since a steep curve can also reflect inflation fears or heavy government borrowing rather than genuine optimism about the economy.
What is a flat curve telling you?
That investors see little difference between lending short and long, usually a transition point where the market is unsure whether rates are heading up or down.
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