A yield curve is a line that plots yields or interest rates of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
There are three main shapes of yield curve shapes:
- Normal Yield Curve – Also, known as upward sloping yield curve, it indicates that the yields on longer-term bonds may continue to rise, responding to periods of economic expansion. It starts with low yields for lower maturity bonds and then increases for bonds with higher maturity. Once bonds reach the highest maturities, the yield flattens and remains consistent.
- Flat Yield Curve – A flat yield curve, also called a humped yield curve, shows similar yields across all maturities. A few intermediate maturities may have slightly higher yields, which causes a slight hump to appear along the flat curve. These humps are usually for the mid-term maturities, six months to two years. Such a flat or humped yield curve implies an uncertain economic situation. It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown.
- Inverted Yield Curve – It is opposite to that of a normal yield curve. It slopes downward. An inverted yield curve means that short-term interest rates exceed long-term rates. Such a yield curve corresponds to periods of economic recession, where investors expect yields on longer-maturity bonds to become even lower in the future.