Interest Rates and Yield Curves
Now that you understand what drives rate changes (inflation, Fed policy), you can interpret yield curves and their economic signals.
Interest Rates
- Interest rates represent the cost of borrowing money
- The Fed influences short-term rates through monetary policy; market forces drive long-term rates
- Interest rates and bond prices have an inverse relationship
When interest rates rise:
- Bond prices fall as yields rise
- Borrowing costs increase
- Economic activity slows
When interest rates fall:
- Bond prices rise as yields fall
- Borrowing costs decrease
- Economic activity increases
Why does this happen? Imagine you own a bond paying 3% interest. If new bonds start paying 5%, nobody wants your 3% bond at full price anymore. You'd have to sell it at a discount. That's why rising rates push bond prices down.
Yield Curve Types
A yield curve plots interest rates (yields) of bonds with equal credit quality across different maturities. Most commonly plotted using U.S. Treasury securities (risk-free benchmark).
| Type | Shape | Long vs Short Rates | What It Signals |
|---|---|---|---|
| Normal (upward sloping) | Upward sloping | Long-term > Short-term | Healthy economic growth expected |
| Inverted (downward sloping) | Downward sloping | Short-term > Long-term | Recession signal; historically reliable predictor |
| Flat | Level | Rates approximately equal | Economic uncertainty; transition period |
| Steep | Sharply upward | Long-term >> Short-term | Strong economic expansion expected; often seen at beginning of recovery |
Yield Curve and Business Cycle Relationship
- Steep curve - typically found at the bottom of the cycle (beginning of expansion); short-term rates are low (Fed stimulus)
- Flattening curve - occurs during expansion as the Fed raises short-term rates
- Inverted curve - typically precedes a recession; short-term rates exceed long-term rates
- Re-steepening - occurs during contraction as the Fed cuts short-term rates
Exam Tip: Gotchas
- Inverted curve = recession warning. An inverted yield curve has preceded each of the last 8 recessions. It is the most reliable recession predictor tested on the exam.
Credit Spreads
- Credit spread - the difference in yield between a corporate bond and a comparable-maturity Treasury security (the risk-free benchmark)
- Represents the additional yield investors demand for taking on credit (default) risk
- Expressed in basis points (1 basis point = 0.01%)
| Economic Condition | Credit Spread Behavior |
|---|---|
| Expansion | Spreads narrow (confidence is high, default risk perceived as low) |
| Recession | Spreads widen (uncertainty rises, default risk perceived as higher) |
- Widening spreads indicate increasing concern about credit quality and economic weakness
- Narrowing spreads indicate improving confidence in credit quality and economic strength
- Lower-rated bonds (high yield/junk) have the widest credit spreads
Exam Tip: Gotchas
- Credit spreads widen during recessions (more risk) and narrow during expansions (less risk). Do not confuse the yield curve (plots maturities) with credit spreads (compares credit qualities).