Yield Curve

A yield curve is a graph that plots the interest rates (yields) of bonds with the same credit quality across different maturities, from short-term (3 months) to long-term (30 years). It shows the relationship between time to maturity and yield, and is one of the most widely watched economic indicators.

What Is the Yield Curve?

The most commonly cited yield curve is for government bonds (US Treasury bonds or Indian government bonds). Each point on the curve represents the yield investors demand for lending money for that duration.

In a normal economy, longer-term bonds have higher yields because:
– Investors demand compensation for the risk of locking in money for longer
– Inflation and credit risk over longer periods are harder to predict

Types of Yield Curves

**Normal (upward sloping)**: short-term rates lower than long-term rates; reflects expectations of future growth and moderate inflation. Typical during expansion.

**Flat**: short-term and long-term yields are similar; often seen during transitions between economic phases.

**Inverted**: short-term rates higher than long-term rates; signals that investors expect future economic weakness or rate cuts.

**Steep**: long-term rates significantly higher than short-term; often seen early in economic recovery when rate cuts are in place.

Why the Yield Curve Matters

– **Economic signal**: an inverted yield curve has preceded nearly every US recession since the 1960s
– **Bank profitability**: banks borrow short-term and lend long-term; a flat or inverted curve squeezes bank margins
– **Investor positioning**: the curve shape guides bond duration decisions in fixed income portfolios
– **Monetary policy signalling**: the shape reflects market expectations of future central bank actions

Practical Example

In India, when RBI raised rates aggressively in 2022-23, short-term government bond yields (1-year) rose quickly while long-term yields (10-year) rose less steeply. The curve flattened, signalling that markets expected rates to eventually come down.

Key Takeaways

– The yield curve plots bond yields across different maturities for a given credit quality
– A normal curve slopes upward; an inverted curve (short-term yields above long-term) signals recession risk
– The 10-year minus 2-year yield spread is the most watched yield curve indicator globally
– Flat or inverted curves reduce bank profitability and often precede economic slowdowns
– In India, the G-Sec yield curve (published by RBI and CCIL) is the reference for government bond pricing