A yield curve plots the yield to maturity (TYM) of similar debt securities, against the time to maturity (term). A normal yield curve is upward-sloping and shows higher yield for longer maturity due to the risks associated with the passage of time. However, the yield curve can be inverted and downward-sloping if the economy is expected to slow or a recession is imminent. Actual observed yield curves can be any kind of shape.
The term structure of interest rates refers to the relationship between short-term and long term interest rates. It connects monetary policy and investment decision as short-term interest rates are affected by monetray policy but investment depends on long-term interest rates. Three main theories explaining this relationship are:
- Pure Expectations Theory suggests that the yield depends on market participants’ expectations on future interest rates, and the long term rate is an average of the short term rates. If the short-term rates are expected to rise in the future, then the theory says the yield curve is upward-sloping (and vice versa). If the short term interest rates are expected to rise and then fall, then we will have a humped yield curve.
- Liquidity Preference Theory suggests that in addition to expectations on future interest rates, long term interest rates also include a liquidity premium for a longer holding period. This suggests the yield curve slopes upward.
- Market Segmentation Theory explains that the yield curve is a product of supply and demand forces for short-term and long-term securities, and reflects different investor preferences. Furthermore, there are legal and institutional policies that restrict certain investors to purchase securities with a certain maturity range. Under this theory, any type of shape of yield curve is possible.