How to Interpret Interest Rates Compared to Yield Curves

Yield curves for corporate bonds are generally higher than the U.S. Treasury yield curve.

Yield curves track the relationship between interest rates and bond maturities at a given point in time. The bonds must have the same risk characteristics; therefore risk-free U.S. Treasury bonds and corporate bonds cannot be plotted on the same curve. You can interpret interest rates and the direction of the economy by comparing the slope and shape of the U.S. Treasury yield curve over time.

Instructions

1. Get the current U.S. Treasury yield curve. There are several free online sources, including the U.S. Treasury website, that plot the daily yield curve for maturities from periods of one month to 30 years. On this U.S. Treasury yield curve, you can find the yield (y-axis) for any maturity (x-axis). Typically you will have menu options on the left side of the curve that allow you to select a date, compare yield curves for two different dates, and display both nominal and real --- inflation-adjusted --- yield curves.

2. Interpret interest rates from the slope of the yield curve. A yield curve can slope upward, slope downward or be flat. The most common slope is upward, meaning longer-term bonds pay more interest than shorter-term bonds. When short-term rates have been low for a long period of time, as they were through 2009 and 2010 following the 2008 financial crisis, the markets expect that economic growth will eventually lead to higher interest rates. This anticipation --- and not necessarily any action by the U.S. Federal Reserve --- causes intermediate and long-term rates to move up.

   An inverted yield curve means higher rates for short-term maturities and lower rates for long-term maturities. This happens in those rare cases --- such as over the 1979 to 1981 period --- when very high inflation forces the Federal Reserve to hike short-term interest rates. However, the markets anticipate lower future interest rates because high short-term rates tend to slow down the economy, thus reducing future inflationary pressures. A flat yield curve could indicate a "Goldilocks" economy --- not too hot, not too cold --- with no significant changes in interest rates.

3. Evaluate the direction of interest rates from the shape of the yield curve. You will often see market commentary on how "steep" a yield curve is. For example, a December 2010 Bloomberg report interpreted the increasing spread or difference in the two-year and 10-year U.S. Treasury yields as a signal that strong economic growth --- fueled by tax cuts and monetary stimulus --- will lead to inflation, thus forcing the Federal Reserve to raise interest rates. On the other hand, a normal-shaped curve that rises gradually and flattens out as the maturities get longer could signal steady interest rates.

4. Assess interest rates from shifts or movements in the entire yield curve, meaning higher or lower yields across almost all maturities. When the yield curve moves up, it is usually an indication of strong economic growth and higher interest rates. When yield curves move down, it could signal lower growth and inflation expectations, and thus lower interest rates.

References

• Bloomberg Businessweek: U.S. Yield Curve Steepest Since February on Tax-Cut Extension; December 2010

Resources

• U.S. Department of the Treasury: Resource Center: Treasury Yield Curve