The yield curve is perhaps the single most important indicator of the market’s expectations about the economy in general and bond yields in particular. A graph such as the one shown here allows investors or traders to compare at a glance the returns on bonds of varying quality and terms. The yield curve derives its shape primarily from two factors:
An upwardly sloping yield curve, as depicted here, indicates that the market
expects higher inflation in the future than at present. This is typically the case in a
growing economy and that is why this shape of the yield curve is most commonly seen. The
higher the expectations of future inflation, the steeper the curve.
However,
if inflation is expected to fall in the future, as when an economic recession is
impending, the yield curve can be downward sloping. A relatively flat yield curve
indicates that the market expects inflation to remain steady, with little economic growth.
The upward slope of the yield curve also represents the market’s perception that a longer-term investment is more risky than a shorter one. Since the accuracy of predicting economic events declines as we predict farther into the future, investors demand a higher return for bonds maturing late. Borrowers, for their part in the market, are willing to pay a higher rate for longer-term debt because it offers them the certainty of a fixed cost of capital irrespective of future volatility in the economy or the financial markets. The perception of risk also plays into the higher returns demanded of an issue of lower quality: As depicted in the graph, a Baa rated bond must pay 60 basis points more than a Aaa bond before an investor would consider it to be of value.