What is a yield curve, and how do you read them? How has the yield
curve moved over the past 25 years?
Yield curves track the relationship between interest rates and the maturity
of U.S. Treasury securities at a given time. The slope, shape, and level
of yield curves may vary over time with changes in interest rates. Analysts
often look at yield curves because they may provide clues to financial
market conditions and future interest rates. We’ll compare several
yield curves and see what information they might provide economists.
How do you build a yield curve?
Let’s start by describing the typical yield curve—each curve
provides a snapshot of the term structure of interest rates. A yield
curve plots interest rates on U.S. Treasury securities as of a particular
date by their maturity—by how many months or years in the future
they will mature. Note that by using only Treasury securities all the
securities have similar characteristics—such as risk and tax status.
A typical yield curve for Treasury securities might include the interest
rates for a series of maturities, ranging from the short-term (three-month
Treasury bills) to the long-term (ten- or twenty-year Treasury bonds).
Chart 1 provides a sample yield curve for July 30, 2004. Remember, you
can plot yield curves daily because interest rates may change daily.
In the charts below, we create average yield curves for longer periods,
months, or years, and use those to compare the term structure of interest
rates for different time periods and to observe trends and shifts in
Slope, shape, steepness, shifts
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.
More about the slope of the yield curve
Over the past
25 years, by far the most common shape of the yield curve has been upward
sloping, meaning that yields rise as the maturity of
the security lengthens—or to put it another way, longer term securities
pay higher returns. An upward sloping yield curve suggests that financial
markets expect short-term interest rates to rise in the future. Clearly,
in 2004, this makes sense because short-term interest rates are already
at or near their lowest level in more than four decades. Upward sloping
yield curves (calculated from monthly average interest rates) for two
months, July 2003 and July 2004, are compared in Chart 2. Note also that
the steeper the slope of a yield curve, the faster interest rates rise
as maturity lengthens.
In addition to the slope of the yield curve, we also are interested
in changes or shifts in yield curves over time. The upward shift in the
yield curve from July 2003 to July 2004 most likely reflects increased
strength in the overall economy over the period rather than an increase
in inflation expectations. Real GDP growth more than doubled on a year-over-year
basis from the second quarter of 2003 to the second quarter of 2004,
while economists projected little change in inflationary expectations
over the two periods.
Occasionally, typically during periods of tight monetary policy, short-term
interest rates may rise above long-term rates and the yield curve becomes
partially or entirely inverted or downward sloping. Downward sloping
yield curves (calculated from annual average interest rate data) for
the years of 1979 and 1981 are shown in Chart 3; a downward-sloping yield
curve generally implies that for both years the financial markets expected
lower short-term interest rates in the future. During the late 1970s
and early 1980s, the U.S. economy experienced a period of rapid inflation
and high interest rates. The upward shift in the yield curve from 1979
to 1981 likely reflected the surge in inflation and higher inflation
expectations over this period when inflation rose at double digit rates.
Finally, yield curves also may be flat across the maturity
spectrum, as they were most recently for the years 1989 and 2000, shown
4. In these two years there was little premium for holding longer term
securities. Let’s examine the shift in the yield curve between
these two periods. In 1989, interest rates for all maturities were
yielding around 8.5 percent, whether they were for 3-month or 20-year
Treasuries. Between 1989 and 2000, the yield curve shifted down around
2.4 percentage points for each maturity, so that by 2000, the yield
curve was again flat—but this time at a lower level, around 6
The difference in the level of the yield curve between these two periods
likely reflects a significant change in inflation expectations from 1989
to 2000. In 1989, the Federal Reserve Bank of Philadelphia’s Survey
of Professional Forecasters (http://www.phil.frb.org/econ/spf/) average
one-year ahead inflation forecast for the Consumer Price Index was 4.6
percent; by 2000 the inflation forecast had dropped 2 percentage points
to 2.6 percent. Between these two periods with flat yield curves, the
yield curve shifted down about 2.4 percentage points while inflation
expectations fell about 2 percentage points.
Finally, let’s give you some historical perspective by plotting
several annual yield curves taken from the period from 1981 to 2003.
Remember that over this period you could have calculated a yield curve
for every day! First, the curves shown in Chart 5 illustrate how the
yield curve has been moving down over time as interest rates have generally
declined over time. One key reason is the decline in the inflation rate;
measured by the CPI, inflation fell from over 13.5 percent in 1981 to
2.3 percent in 2003. Notice also that among the flat and upward sloping
curves shown, the steepness shows a lot of variability from year-to-year—be
aware that daily curves will show much more variation than yield curves
calculated from annual average data. The 2003 yield curve is the steepest
shown, mainly reflecting the fact that short-term interest rates have
been lowered to historically low levels by the Federal Reserve’s
efforts to stimulate the economy.
Additional Information: Building your own yield curve
Interest rate data for U.S. Treasury securities are available from the
Federal Reserve Board’s H.15
Release, Selected Interest Rates.
That’s a great place to go if you would like data to calculate
your own yield curves. Instruments
of the Money Market, published by the Federal Reserve Bank of Richmond,
provides additional background information on yield curves in its chapter
on Treasury Bills.
[urls accessed in September of 2004]
Blanchard, Oliver. (1997) Macroeconomics, Prentice-Hall,
Upper Saddle River, New Jersey. See Chapter 9.
Price Index, Bureau
of Labor Statistics website.
of the Money Market. (1998) Federal Reserve Bank of Richmond. See Chapter
G., and André Kurmann, (2002) Expectations
and the Term Structure of Interest Rates: Evidence and Implications, Economic
Quarterly, Federal Reserve Bank of Richmond. Fall 2002, Vol. 88,
Peter S. (1994) Money and Capital Markets, Irwin, Burr Ridge, Illinois,
See Chapter 9 for additional information on the structure of interest
Interest Rates, Federal Reserve Board of
of Professional Forecasters, Federal Reserve Bank of Philadelphia
Joseph E., and Carl E. Walsh. (2002) Principles of Macroeconomics. W.W.
Norton & Company, New York. See Chapter 4.