Yield Curve Explained｜Basics, Shapes, Movements, and Theories

1. Overview

The yield curve plots interest rates (yields) on the vertical axis against time to maturity on the horizontal axis, connecting yields of bonds with different maturities. It provides a one-glance picture of the interest rate environment and investors’ expectations.

2. Basics of the Yield Curve

The yield curve shows the relationship between maturity and yield for bonds issued by a particular entity (e.g., government bonds). Generally, the longer the maturity, the higher the uncertainty and price risk, so longer maturities tend to command higher yields.

(Additional explanations such as candlestick “bodies” and “wicks” can be added in context if necessary.)

3. Common Shapes and Interpretations (Normal, Flat, Inverted)

• Normal Yield Curve: Upward sloping; longer maturities offer higher yields. The most typical shape.
• Flat: Little difference between short- and long-term yields. Often seen when views on rates are evenly balanced.
• Inverted: Downward sloping; short-term yields exceed long-term yields. Often viewed as a signal of potential recession, but not a guarantee. Must be considered with other indicators. Over time, curves may shift from “normal → flat → inverted.”

4. Movements of the Curve (Steepening / Flattening)

• Steepening: Curve slope becomes sharper. In a normal curve, caused by rising long-term yields or falling short-term yields. If driven by long-term rise, it’s a “bear steepening.” If by short-term drop, it’s a “bull steepening.”
• Flattening: Curve slope becomes gentler. In a normal curve, caused by rising short-term yields or falling long-term yields. If driven by short-term rise, it’s a “bear flattening.” If by long-term drop, it’s a “bull flattening.”

5. Key Theories Explaining Curve Shapes

Main Theories

• Pure Expectations Hypothesis: Long-term rates equal the expected average of future short-term rates. Rising expected future short rates → upward slope.
• Liquidity Premium Hypothesis: Long-term bonds include a risk premium for liquidity and price volatility, leading to higher long-term rates.
• Market Segmentation Hypothesis: Different investors focus on different maturities, forming separate markets with limited arbitrage. For example, banks prefer short maturities, while insurers favor long maturities.

6. How to Check It and Policy/Strategy Links

• How to Check: Yield curves can be viewed through data provided by brokers or government agencies. Tools often allow comparison across dates and maturities.
• Policy/Strategies: Yield Curve Control (YCC) is a policy where central banks target short- and long-term yields. For example, the Bank of Japan has guided short-term rates (its negative rate policy ended in March 2024) and targeted 10-year government bond yields with adjustable caps. Yield curve strategies include trades such as “steepeners” (betting on steepening) and “flatteners” (betting on flattening). These are explained here for terminology, not as trading advice.

7. Summary

The yield curve is a basic tool that maps maturities to yields, offering insights into interest rate conditions and expectations. Key shapes are normal, flat, and inverted, while steepening and flattening movements provide dynamic signals. Theories such as expectations, liquidity premium, and market segmentation help explain shapes. Interpretation should always be combined with other information like policy and economic indicators.

8. Frequently Asked Questions

Q1. What does an inverted yield curve signal?

A1. It means short-term yields exceed long-term yields. Historically, this has often preceded recessions, but it’s not a guarantee—always cross-check with other indicators.

Q2. How does the yield curve relate to central bank policy?

A2. Short-term yields are strongly influenced by central bank policy rates, while long-term yields reflect expectations of future rates, inflation, and risk premiums. Policies like YCC directly shape the curve.

Q3. Can investors use yield curve strategies?

A3. Yes, strategies like “steepeners” or “flatteners” aim to profit from curve shifts. However, these are advanced trades and require careful risk management. This explanation is educational only, not a recommendation.