The Treasury Yield Curve is an important economic barometer that is watched closely by both investors and economists for clues about the future direction of the economy and interest rates. So what do you as an investor need to know about the Treasury Yield Curve?
A good starting point is to understand exactly what the curve is depicting. The Treasury Yield Curve is literally a “curve” on a graph that demonstrates the interest rate (or yield) currently being paid on Treasury bonds of varying fixed maturities. It typically plots interest rates for Treasury bonds with maturities of one, three and six months and one, two, three, five, seven, ten, twenty and thirty years.
The Treasury Yield Curve is commonly used by banks and other sources of financing as a benchmark for setting interest rates on other kinds of debt, such as mortgages, car loans and home equity lines of credit. It can also help economists to forecast the future direction of the economy. The curve typically takes one of the following shapes:
- Normal —The normal yield curve indicates that longer-maturity Treasury bonds (e.g., thirty-year bonds) offer higher yields than shorter-maturity Treasury bonds (e.g., one-month bonds). This is because there is more risk involved in holding onto the bond for a long period of time, so investors are compensated for this risk with higher yields. This curve features an upward sloping line, moving from left to right.
- Inverted — As the name implies, an inverted yield curve occurs when shorter-maturity Treasury bonds offer higher yields than longer-term Treasury bonds. In this scenario, investors believe the economy will contract in the future; therefore, inverted yield curves have historically been a good predictor of future recessions. This curve is the opposite shape of a normal yield curve.
- Humped yield curve —This yield curve represents higher yields on medium-term Treasury bonds (e.g., five- or seven-year bonds) than those on long- or short-term Treasury bonds. It features a straight line with a camel’s hump in the middle. This usually indicates uncertainty among investors about both current and future economic conditions.
- Flat yield curve —A flat yield curve shows that the yields of all Treasury bonds are about the same. Essentially a straight line, this yield curve also usually signals economic uncertainty.
The slope of the yield curve is also something to keep an eye on. If a normal yield curve is steep — in other words, if the upward sloping line juts up sharply — this indicates a large gap between short-term and long-term Treasury bond yields. For example, the yield on twenty-year Treasuries has historically averaged about two percentage points higher than the yield on three-month Treasuries. If this difference grows to three percentage points or more, this would result in a steep yield curve, which is usually an indication that the economy is on the verge of expansion.
It is important to have at least a basic understanding of the Treasury Yield Curve and what its shape might indicate about the economy and the future direction of interest rates. This could help you make more informed investment decisions — and possibly increase your investment returns over time.