UNDERSTANDING A YIELD CURVE

A yield curve demonstrates the relationship between bond maturities and their yields. By plotting the yields of bond maturities from shortest to longest, you can predict overall interest rate trends.

A yield curve is drawn as a simple graph with annual yield on its left side and bond maturities on its bottom.

In the above graph, the longer the maturity of the bond, the higher the yield.

The direction of the yield curve is highly influenced by inflation. If investors believe that inflation will rise, they will sell long-term bonds because they would suffer the most from inflation. The falling bond prices would increase the yield of the long-term bonds, making the return curve steeper. Conversely, if inflation is expected to slow, investors will buy more long-term bonds than short-term ones, flattening the curve and possibly inverting it.

Interest rates have the most dramatic effect on the yield curve. If interest rate changes are the same for bonds with different maturities, the curve is said to be undergoing a parallel shift. This does not happen very often. When the difference between short-term and long-term interest rates increases, the curve steepens. When the difference decreases, the curve flattens.

Once you know how to read a yield curve, you can use it to understand the market's expectation for the future of the economy.