The yield curve shows the relationship between the yield of a fixed-income security and the length of time until its maturity. This is expressed visually on a graph with the yield as the horizontal axis while maturity is the vertical axis. Investors examine the shape of the yield curve in order to see clues as to future interest rate movements.
Normal Yield Curve
The normal yield curve will reflect a market environment that tends to reward investors for investing in longer-term bonds, despite the increased risk compared to shorter-term bonds. A normal yield curve reflects an increase in yield as maturity time increases. Visually the normal yield curve looks like a concave arc starting from the bottom left of the graph and then ending in the top right of the graph.
Flat Yield Curve
When the yield curve visually looks closer to a flat line it is known as a flat yield curve. This represents a marketplace where yields are essentially the same among fixed-income securities of all maturity times. Investors, in this type of market condition, will accept yields on longer-term instruments which do not cost a premium above shorter-term yields. Generally, this is a sign that market participants feel the economy does not have much growth capacity and are therefore betting on stable short-term interest rates.
Inverted Yield Curve
Investors looking to avoid risk will want to be careful when they notice an inverted yield curve. This signal generally expresses negative market sentiment for future economic conditions. A possible recession or prolonged economic downturn may be in the cards when an inverted yield curve is present.
An inverted yield curve will visually look like a slope heading downwards over time on the graph. This indicates that longer-term bond yields have fallen below bonds with short-term yields. This implies that investors believe that the long-term economic outlook will include falling bond prices.
Humped Yield Curve
Other times the yield curve will reflect a marketplace that expects short-term economic growth. This is what is reflected by a humped yield curve. Visually the humped yield curve looks exactly as the name would suggest, a hump-like convex curve. This reflects equal short-term and long-term yields, however medium-term yields are significantly higher. Although short-term economic expectations are positive, the humped curve also indicates that market participants do not expect long-term economic growth to be sustainable.
On the other hand, these methods of interpreting the shape of the yield curve and its implications on the economy and the markets are only theory. Just like any other type of market forecasting techniques the yield curve is only one perspective. Investors and traders should also consider various other fundamental, technical and market sentiment factors when making decisions.
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Sources:
fxtrade.oanda.com/learn/intro-to-currency-trading/fundamental-analysis/monetary-policy
