Quick Answer
Interest rates and bond prices move inversely: rates up, prices down. A yield curve plots yields across maturities; normal slopes up, inverted slopes down (the most reliable recession signal), flat is roughly level, and steep signals strong expected growth. Credit spreads, the extra yield over Treasuries, narrow in expansions and widen in recessions.
Now that you understand what drives rate changes (inflation, Fed policy), you can interpret yield curves and credit spreads as the market's own read on where the cycle is headed.
Why Do Bond Prices Move Opposite to 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 would have to sell it at a discount. That is why rising rates push bond prices down.
Which Moves More: Rates or Prices?
Short-term and long-term rates do not move the same way, and neither do short-term and long-term bond prices. These are two separate comparisons, easy to mix up.
- Short-term rates are more volatile than long-term rates. The Fed's tools act directly on the short end of the curve, so short-term rates swing more often and more sharply as policy shifts. Long-term rates reflect the market's average expectation for rates over many years, so they move more slowly.
- Long-term bond prices react more to a given rate change than short-term bond prices. A bond's cash flows are locked in for its full term, so the longer that term, the more years of cash flows get repriced when rates move. This is the idea behind duration, covered in depth in Fixed Income Characteristics.
Exam Tip: Gotchas
- Rate volatility and price volatility point to opposite ends of the curve. Short-term rates move around more, but it is long-term bond prices that move around more when rates change. A "more volatile rate" and a "more volatile price" are not describing the same maturity.
What Do the Different Yield Curve Shapes Signal?
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 |
How Does the Yield Curve Relate to the Business Cycle?
- 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
- An inverted yield curve, short-term rates above long-term rates, is the most reliable recession predictor tested on the exam. It is a warning sign, not a certainty.
What Do Credit Spreads Signal?
- 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 for one credit quality) with credit spreads (compares credit qualities at one maturity).
What Should You Check on Exam Day?
- Know the inverse relationship between rates and bond prices, and be able to explain why in your own words
- Keep rate volatility (short end moves more) separate from price volatility (long end moves more)
- Match each yield curve shape (normal, inverted, flat, steep) to its signal and its typical place in the business cycle
- Remember an inverted curve is the exam's most reliable recession predictor
- Know that credit spreads narrow in expansions and widen in recessions, and that lower-rated bonds carry the widest spreads