What A Yield Curve Describes

A yield curve plots the return available on a government's bonds against how long each has left to run. The shape of that line is watched closely, and the reasons are specific.

The curve is built from comparable bonds

Yields are taken from bonds of a single issuer across a range of maturities, so credit quality is held constant and only the time dimension varies.

Each point shows what an investor earns for lending to that issuer for that period, as determined by current market prices.

Because the issuer is the same throughout, differences along the curve reflect the term rather than the borrower.

Upward sloping is the common shape

Longer lending usually pays more, compensating for the greater uncertainty about inflation and rates over an extended period.

This term premium is the additional return demanded for accepting exposure to conditions further into the future.

A gently rising curve is therefore the ordinary state and carries little information by itself. Attention concentrates on departures from it.

Inversion reverses the usual relationship

When short-term yields exceed long-term ones, the market is pricing lower rates in future than it expects in the near term.

Such expectations typically accompany a view that policy rates will be reduced, which is usually associated with weakening economic conditions.

This is why inversion attracts attention as an economic signal, though the relationship between the shape and subsequent conditions has varied and the timing has never been consistent.

Expectations and supply both shape it

Part of the curve reflects expected future policy rates. Another part reflects the supply of bonds at each maturity and the demand from those who must hold them.

Institutions with long-dated obligations buy long-dated bonds regardless of relative value, which affects yields at that end independently of expectations.

Central bank purchases and sales of bonds at particular maturities also influence the shape, which complicates reading the curve as pure expectation.

It feeds through to other borrowing

Government yields serve as reference rates for other lending, so corporate borrowing costs and mortgage rates are quoted at a margin above comparable points on the curve.

A change in the curve therefore propagates into the cost of credit across the economy, not only into bond portfolios.

Curves exist for other issuers and currencies too, and comparing them shows how differently borrowing costs are set across jurisdictions with different conditions and policy settings.