Yield curve and its types

A yield curve is a graphical representation that illustrates the relationship between interest rates and the maturity of debt securities, usually government bonds. It plays a key role in reflecting investor sentiment about future interest rates and economic activity, serving as an important tool for financial analysis.

There are three main types of yield curves:

• normal.
• inverted.
• flat.

A normal yield curve has an upward slope, indicating that longer-dated bonds have higher yields than short-dated bonds, reflecting expectations of economic growth.

An inverted yield curve, in which short-term rates exceed long-term rates, often signals an impending recession.

A flat yield curve indicates uncertainty about future economic conditions.

A normal yield curve is usually upward sloping, reflecting higher interest rates for long-term bonds. This situation indicates a healthy economy where investors expect growth, leading to increased demand for long-term investments. In this case, zero coupon bonds provide an attractive opportunity to lock in yields for the long term.

In contrast, an inverted yield curve occurs when short-term interest rates exceed long-term interest rates. This phenomenon usually signals an impending economic slowdown or recession, as investors prefer to lock in higher yields for shorter maturities, increasing demand for zero-coupon bonds as a safe haven.

A flat yield curve is characterized by little difference between short-term and long-term interest rates, indicating uncertainty in the economic outlook. During this period, investors may look for zero coupon bonds to manage risk while the market stabilizes.

For lenders, a flat yield curve may also indicate that we will soon enter a period of low inflation expectations. Lenders and investors want long-term investment returns to offset the effect of inflation on their investments. However, when the yield curve flattens and low inflation is expected, investors will be less concerned about the impact of inflation and will consider the opportunity cost of long-term investments.

Simply put, when the yield curve is flat, investors get the same returns from short-term and long-term investments. This can have many effects on the market, including decreased interest in long-term investments due to the lack of net benefit compared to short-term investments. In such a market, many investors will lean toward short-term bonds, avoiding long-term bonds because they do not carry the risks associated with freezing finances in long-term bonds for the same return and potential.

Yield curve risk refers to the unfavorable impact of changes in interest rates on bond yields. It arises because bond prices and interest rates have an inverse relationship. Bond prices in the secondary market fall when market interest rates rise and vice versa.

For example, if the bond yield curve indicates that the economy is slowing down, an investor may move their funds into defensive assets that traditionally perform well during a recession.

There are several theories to explain why an inversion of the yield curve may indicate a recession. One theory is that it reflects investors' expectations of lower interest rates in the future. When investors expect interest rates to fall, they buy bonds with longer maturities that will yield higher yields once interest rates fall. This leads to higher prices for longer maturity bonds and therefore lower yields.

Another theory is that the inversion of the yield curve reflects investors' expectations of slower economic growth. When the economy slows, investors demand higher yields for higher risk. This leads to higher yields on shorter maturity bonds, which are considered riskier than longer maturity bonds.

Historical patterns

Historical data mostly confirms that an inversion indicates a potential decline in economic activity following an exit.

Throughout history, yield curve inversion has often preceded a recession. However, it is important to note that yield curve inversion is not an accurate indicator of a recession. In some cases, a yield curve inversion has not led to a recession, and in other cases, a recession has occurred without a yield curve inversion.

As you know, in the current realities we are also in a 10y 2y notes inversion but whether there will be a recession this time is unknown. This cycle is not like the previous ones, so no one can answer this question with precision.