A normal yield curve, also known as a positive yield curve, is a visual tool that shows the direct relationship between the interest rate and time to maturity of an investment. It is observed when short-term investments yield a lower rate of return than long-term investments. When graphed, the normal yield curve is an upward sloping asymptote. When the curve reaches its peak, it generally flattens out as the marginal increase diminishes.
The upward slope demonstrates that investors expect to be compensated for the additional risk associated with investing money for longer periods of time. These risks include fluctuating interest rates, missing out on more profitable investment opportunities, and the possibility of default. The time value of money may also change so that the value of the dollar today is more valuable than the value of the dollar tomorrow. The longer an investor’s money is tied to an investment, the more chance he has of encountering risk and losing money.
There are three types of yield curves: the normal yield curve, the inverted yield curve, and the flat yield curve. The normal yield curve is present when investors have confidence in the growing economy and expect inflation to rise over time. During periods of deflation, when prices decline, the yield curve becomes inverted. This is because investors believe the dollar will be more valuable in the future than it is today. When a flat yield curve is present, it is a sign the economy is slowing down.
The most common use for the normal yield curve is as a benchmark for debt, such as stocks, futures, options, commodities, Forex, and bonds. The three-month, two-year, five-year, and 30-year U.S. Treasury debt is usually used to construct the yield curve, because U.S. Treasury debt is considered to be risk-free from defaulting. Investors compare the yield curve of investments against the U.S. Treasury yield curves to verify that they will be compensated fairly for the risk.
The overall shape of the yield curve is determined by current economic conditions and the confidence of investors for the future. Therefore, the yield curve changes as the state of the economy changes. When a normal yield curve is present, it shows that investors have confidence in the economy and the future. When the yield curve starts to shift to a flat yield curve, then it could mean the economy is slowing down and a recession is approaching.