What is the Yield Curve?

If you’ve been watching or reading much economic news, invariably you would’ve heard of the term yield curve. It refers to the interest rates on Treasury debt and it’s important because it can give us a quick glimpse at the health of our economy. If you’ve ever wondered what it was, here’s a crash course.

Vanguard, in their latest In The Vanguard, has a great explanation of what yield curves are. In short, there are three types:

  • Normal – where interest rates rise as you increase the maturity time
  • Flat – where interest rates rise in a nearly horizontal line as you increase maturity time
  • Inverted – where interest rates fall as you increase maturity time

The yield curve means different things to different people, as we are always looking to invest and save in different products. For economists and talking heads, they are referring to the interest rate on Treasury debt, like notes and bonds. For the rest of us, the yield curve we care about is usually something like CD rates. Whatever the underlying asset, the idea is still the same.

Why are they popular for economics? Inverted yield curves have preceded many recessions. The yield curve inverted in 2000 just before the dot com bust. The yield curve was inverted again in early 2007, which preceded our more recent crisis. Is it a perfect predictor? No, but it’s good enough to keep some people on television.

How does it affect us? When the curve is normal or flat, we understand that we are getting a higher interest rate for locking up our money for a longer period of time. 5-year CD rates are higher than 1-year CD rates and we understand why. When the curve is inverted, we get confused because instead of being rewarded, we are being penalized for giving up flexibility. Fortunately, I’ve never seen a bank’s CD rates form an inverted curve.

While the yield curve has little impact on our daily lives, it’s still important to understand what it means from a broader perspective.

Jim writes about money at his personal finance blog, Bargaineering.com.