Additional Detail on Interest Rates

A yield curve shows the relationship between interest rate levels (or cost of borrowing) and the time to maturity. It also tells what investors' expectations for interest rates are and whether they believe the economy will expand or contract. Three variables determine interest rates: inflation rate, GDP growth, and the real interest rate.

Using the Yield Curve to Estimate Interest Rates in the Future

The yield curve tells what investors' expectations for interest rates are and whether they believe the economy is going to be expanding or contracting.


LEARNING OBJECTIVE

  • Estimate interest rates using a yield curve

KEY POINTS

    • A normal yield curve tells us that investors believe the Federal Reserve is going to raise interest rates in the future.
    • A flat yield tells us that investors believe the Federal Reserve is going to be cutting interest rates.
    • An inverted yield curve tells us that investors believe the Federal Reserve is going to dramatically cut interest rates.
    • A flat curve expects unchanged interest rates in the future, sending signals of uncertainty in the economy.
    • An inverted yield curve occurs when long-term yields fall below short-term yields, indicating a fall in interest rates in the future.

TERMS

  • treasury bill

    Treasury bills (or T-Bills) mature in one year or less. They do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity.

  • Treasury bond

    Treasury bonds (T-Bonds, or the long bond) have the longest maturity of government securities, from 20 to 30 years. They have a coupon payment every six months, and are commonly issued with maturity of 30 years


A yield is the return an investor will receive by holding a bond to maturity. The yield curve is a simple financial chart or graph. The shape of the yield curve indicates the cumulative priorities of all lenders relative to a particular borrower (such as the US Treasury or the Treasury of Japan). The line on a yield curve chart plots the interest rate of bonds at set times and gives the relation between the interest rate to be paid to the bond holder and the time to the maturity of the bond. Sometimes these curves are referred to as the term structure of interest rates.

The yield curve is normal, meaning that yields rise as maturity lengthens (i.e., the slope of the yield curve is positive). This positive slope reflects investor expectations for the economy to grow in the future and, importantly, for this growth to be associated with a greater expectation that inflation will rise in the future rather than fall. This expectation of higher inflation leads to expectations that the central bank will tighten monetary policy by raising short term interest rates in the future to slow economic growth and dampen inflationary pressure. It also creates a need for a risk premium associated with the uncertainty about the future rate of inflation and the risk this poses to the future value of cash flows. Investors price these risks into the yield curve by demanding higher yields for maturities further into the future.

The yield curve can tell us a lot about investors' expectations for interest rates and whether they believe the economy is going to be expanding or contracting. Yield curves come in three standard types: the normal yield curve, the flat yield curve and the inverted yield curve.

A normal yield curve tells us that investors believe the Federal Reserve is going to raise interest rates in the future. Typically, the Federal Reserve only has to raise interest rates when the economy is expanding and the Fed is worried about inflation. Therefore, a normal yield curve often precedes an economic upturn.


Normal Yield Curve: A normal yield curve tells us that investors believe the Federal Reserve is going to raise interest rates in the future.

A flat yield curve shows that investors believe the Federal Reserve is going to cut interest rates. Interest rates tend to make cuts when the economy is contracting and the Fed is trying to stimulate growth. As a result, a flat yield curve is often a sign of an economic slowdown.


Flat Yield Curve: A flat yield tells us that investors believe the Federal Reserve is going to cut interest rates.

An inverted yield curve demonstrates that investors believe the Federal Reserve is going to dramatically cut interest rates. Typically, the Federal Reserve has to cut interest rates during a recession. An inverted yield curve indicates that the economy is in, or is headed for, a recession.


Inverted Yield Curve: An inverted yield curve tells us that investors believe the Federal Reserve is going to dramatically cut interest rates.

Sometimes, treasury bonds yield averages higher than treasury bills (e.g. 20-year treasury yield rises higher than the three-month treasury yield). In situations when this gap increases, the economy is expected to improve quickly in the future. This type of steep yield curve can be seen at the beginning of an economic expansion (or after the end of a recession). Here, economic stagnation will have depressed short-term interest rates; however, rates begin to rise once the demand for capital is re-established by growing economic activity. When the yield curve is steep, we can expect a great increase in interest rates in the future