Before getting started, a brief definition is in order: the yield curve represents the relationship between the interest rate (or yield) on government bonds (or other debt instruments) and their maturity. In other words, it shows how much yield investors require to lend money over different periods (short, medium and long term).

There are three types of yield curves:

  • The normal or rising yield curve
  • The flat yield curve
  • The inverted or descending yield curve

Let's take a closer look at each of these three possibilities and place them in their respective macroeconomic context.

The rising yield curve

This is the normal situation, where the curve rises from left to right. Short-term interest rates are lower than long-term rates. This generally reflects a healthy growing economy, where investors expect long-term interest rates to rise due to anticipated inflation and economic expansion. Central banks may raise short-term interest rates to prevent the economy from overheating.

Investment strategy: Investors prefer long-term investments to achieve higher returns.

The flat yield curve

The curve is relatively flat across all maturities. This may indicate economic uncertainty or a transition between different economic phases. Investors have no strong preference for the short or long term, often due to uncertainties about the economic future.

Investment strategy: Investors may be more cautious, diversifying their investments between the short and long term.

The inverted yield curve

The curve slopes from left to right. Short-term interest rates are higher than long-term rates. An inverted yield curve is often seen as a harbinger of recession. It reflects an expectation of lower long-term interest rates due to a pessimistic economic outlook. This is the situation currently observed in the United States.

Investment strategy: Investors avoid long-dated bonds, which yield less than their short-dated counterparts. On the equity market, investors will be on the lookout for tangible signs of recession (rising unemployment, falling consumer spending, declining business indicators, etc.).) which translate into a negative share price on the indices (S&P 500 and Nasdaq 100 in the lead) before making the necessary arbitrages in favor of defensive stocks.

You can find this feature by clicking on the link.

In our next article, we'll be looking at the notions of steepening and flattening of the curve and their implications.