The yield curve is defined as the plot of bond yields with the same credit value versus maturity dates (due dates of principal amounts of bonds). This curve gives investors a few predictors on the future outlook of the economy and the stock market. Yield curves are influenced by macro factors such as interest rates and inflation. As a result, stock market investors, bond market investors, as well as real estate investors should always have an eye on the yield curves. The yield curve is in three types. The normal yield curve (positive trending curve), the inverted yield curve (negative trending curve), and the flat yield curve (near zero slopes).
The normal yield curve is when the bond yield rates are increasing for higher maturity dates. This is a sign of a healthy economy that is positioned for expansion. It is an indicator of investor's confidence in the short-term outlook of the economy. In other words, investors are willing to take the risk to put their money in short-term bonds. This results in higher demand for bonds with shorter maturity dates. As a result, borrowers (governments and corporations) borrow money at a lower rate. This drives the yields to lower values for bonds with short maturity dates. The inverted yield curve is the opposite of the normal yield curve. It is when the investor's confidence in the future of the economy is declining. Therefore, the demand for short-term bonds declines. This drives the yield rates higher for bonds with shorter maturity dates. An inverted yield curve may be an indicator that a recession is imminent. A flat yield curve is when a transition in yield values from higher to lower maturity dates or vice versa is happening. It is an indicator of economic transition. The yield curves are usually reported for three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt.
The yield curve may have implications to predict the stock market. A normal yield curve means higher interest rates and lower inflation. Therefore, investment in cyclical companies is more beneficial during these times. The inverted yield curves mean lower interest rates and higher inflation. Therefore, investors should invest in companies that perform better during an economic slowdown such as growth stocks. Additionally, during any of these yield curve situations, the stock market growth may happen. During low-interest rates and higher inflation, businesses can borrow more money and invest in their business for higher profits in the future. On the other hand, during high-interest rates and low inflations, the economy and businesses are doing well and their revenue and the stock prices surge.