USING YIELD CURVES TO MAKE PREDICTIONS

By looking at the shape of a yield curve in a financial newspaper, you can predict some things about the future state of the economy.

A normal yield curve slopes upward to reflect the difference in risk between short-term and long-term maturities.  The longer your investment, the higher the risk and, therefore, the greater the possible yield.  Under normal circumstances, this is what a yield curve would look like:

When you see a normal yield curve, it means investors expect the economy to grow at a normal, steady pace.  They expect to be rewarded for investing money for long periods.

But we already know that interest rates and inflation change the shapes of yield curves.  A curve that looks like this . . .

… is an example of a steep yield curve.  This means investors believe the economy will grow very quickly.  It signals the beginning of economic expansion, usually at the end of a recession.  Long-term investors want to make sure they are not locked into low, short-term interest rates.

An inverted curve means investors think that economic activity will decline.  They are willing to take low rates now because they fear the rates will be even lower in the future.  Inverted curves are rare and can signal a recession.  They look like this:

Finally, a flat curve indicates that short-term and long-term interest rates are somewhat equal.  A flat curve is often followed by an inverted curve, meaning lower interest rates and economic slowdown are on the way.  A flat or humped curve looks like this:

Before we end this tutorial on yield curves, let's look at some possible reasons yield curves change.