The yield curve shows the relationship between interest rates and the time to maturity of a specific bond or interest bearing security in a particuliar currency. The yield curve will have a measurable shape and slope that will vary over time with changes in interest rates. The yield curve is closely watched because it can provide signs of changing market conditions and future interest rates. With many analysts, the shape of the yield curve is often narrowly studied to help discern patterns of future interest rate changes and economic activity.

The yield on an investment instrument is the annualized percentage increase in the value of that investment. For instance, a bank account that pays an interest rate of 5% per year has a 5% yield. If there is comparison of similar interest bearing securities, the percentage yield per year that can be earned is dependent on the length of time that the money is invested or its maturity.

Any interest bearing investment can be used to plot the rate over varying maturities on a yield curve. The investments used to chart the graph should be different only with regards to their different maturities. The credit risk, liquidity risk and currency type used should be the same throughout the investment securities plotted on the curve. The relation of yield to time is called the yield curve. The yield received on most interest bearing investments are generally an increasing function of time, but not always. For example, a bank may offer different rates on their certificates of deposit, frequently paying higher CD rates if the customer is prepared to leave money untouched for longer periods of time. The most common yield curve depicted is one depicting Treasury securities, since all the securities issued in this class have similar characteristics.

The U.S. Treasury yield curve is a graphicaldisplay of the yields on U.S. Treasury bills, notes and bonds across a wide array of terms or maturities. The points on the U.S. Treasury yield curve depict the interest rates on U.S. Treasury securities as of a specific date by their maturity or by how many months or years in the future they will mature. A usual yield curve for U.S Treasury securities will generally include the interest rates for a string of maturities, ranging from the short-term three-month Treasury bills to the long-term ten-year Treasury bonds. The current U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely watched by many economists and investors.

By analyzing similar interest bearing investments over time a yield curve is designed to provide a quick view of the term structure of interest rates. The slope of the yield curve provides an important clue to the direction of future short-term interest rates; an upward sloping curve generally indicates that the financial markets expect higher future interest rates; a downward sloping curve indicates expectations of lower rates in the future. The shape of a yield curve also may provide clues to future interest rate movements—a humped curve indicating that short-term rates (over the next year) are expected to rise, but that over the long-run (several years) rates are expected to fall. The overall level of the yield curve also may shift up or down—at least in part because of changes in inflationary expectations over time.

Yield curves are used by financial analysts to understand conditions in financial markets and to seek trading opportunities. Because the financial analysts and the buyers and sellers of interest bearing securities have well informed opinions on inflation and interest rates, many consider the yield curve to be a strong indicator of the best available prediction of future interest rates. Since investors have a choice and flexibility on how long and at what rates they will lend and borrow money, it is generally believed that the yield curve is a function of investor’s forecasts of future interest rate levels. Economists use the curves to understand the current interest rate environment and the anticipation of future levels of inflation to monitor economic conditions.

Historically, the yield curve spread, or the difference between short-term and long-term interest rates, has had some predictive power for the performance of the U.S. economy and banking industry. In the past, a narrowing, or flattening, of the spread has tended to foretell both slower economic growth and increased pressure on bank earnings. Furthermore, the yield curve generally has inverted—a condition where short-term rates exceed long-term rates—up to two years ahead of a recession. Based on this historical context, the flattening in the yield curve since mid-2004 has been on the minds of many economists and banking analysts. Sometimes, however, the yield curve flattens or inverts for reasons that may not necessarily foreshadow slower economic growth.

The shape of the yield curve spread also has held implications for bank margins and profits. Historically, bank net interest margins have tended to decline one to two quarters after a decline in the yield curve spread. While many banks have found ways of reducing their sensitivity to changes in yield curve spreads in recent years, the largest banks have seen their margins squeezed substantially by the recent flattening in the yield curve. And although smaller banks have been less affected so far, the earnings of all lenders will likely be affected should the yield curve remain flat for several more quarters.

The Yield Curve and the U.S. Economy

A yield curve is simply a graph depicting the yields of similar debt instruments of differing maturities. There are many yield curves and many ways of measuring the difference, or spread, in short- and long-term interest rates along these curves. A common measure of this difference is the spread between the federal funds rate, which is set by the Federal Reserve and used in pricing overnight interbank loans, and the 10-year Treasury note yield, which is linked to the pricing of traditional fixed-rate mortgages. Two other common measures of the spread take the difference between 3-month and 10-year Treasury yields or the difference between 2-year and 10-year Treasury yields. Some research indicates that calculating spreads using very short-term rates, such as the federal funds rate or 3-month Treasury yield, is a more useful indicator of future economic activity than using a 2-year Treasury yield as a short-term rate.1 In keeping with this prior research, we will focus on the spread between the federal funds rate and the 10-year Treasury yield when measuring the shape of the yield curve.

The shape of the yield curve is closely scrutinized because it helps to give an idea of future interest rate change and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped). A normal yield curve (pictured here) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time. An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession. A flat or humped yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition. The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.

The Yield Curve and Banks

Just as the yield curve is not a perfect indicator of future economic growth, it also does not provide perfect foresight as to how bank net interest margins (NIMs) and earnings will fluctuate. The traditional view of the banking business holds that banks pay interest on their deposits based upon shorter-term interest rates while making loans tied to longer-term interest rates. Thus, the difference between interest paid and received—the margin—should be influenced by the slope of the yield curve. There is some empirical support for this view. For instance, Chart 2 shows that, until recently, overall bank NIM declined over a period of three to six months following a drop in the yield curve spread.

History suggests that the odds of recession increase when the yield curve spread flattens or becomes inverted. But past recessions only occurred with a high frequency after the curve inverted by a significant amount for a sustained period of time. Further, the yield curve spread can invert for reasons other than the possibility of slower economic growth. We have presented some of these possible explanations, which include expectations of lower long-term inflation, a recent reduction in the term premium, strong demand for longer-term debt by foreign central banks, and investment activities by pension and hedge funds. As a result, the flat yield curve spread may not be signaling increased odds of a recession at present. By the same token, the structural forces holding long-term interest rates down may be with us for some time, even as the cyclical increase in short-term rates subsides. The presence of these structural forces suggests that a flat yield curve could persist for some time.

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