Term Structure of Interest Rates Explained

The term structure of interest rates maps out the relationship between interest rates and the time to maturity for a given debt instrument, typically government bonds. Commonly drawn as a yield curve, this seemingly simple concept belies an intricate interplay of economic forces, investor sentiment, and future expectations. Indeed, few metrics gained wider attention among investors in the 2020s than the yield curve.

From predicting recessions to guiding monetary policy, the yield curve's shape has become a crucial barometer of economic health and market sentiment. Below, we'll explore the term structure of interest rates, its components, common interpretations, and implications for the broader economy and your investing strategies. We'll also look at the structure of yields in the 2020s, which has managed to both panic and flummox economists and investors.

Understanding Term Structure Of Interest Rates

Essentially, the term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. When graphed, the term structure of interest rates is known as the yield curve, and it plays a crucial role in identifying the state of the economy. The term structure of interest rates reflects the expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions, as seen below.

As above, the most common yield curve depictions use rates from three-month, two-year, five-year, 10-year, and 30-year U.S. Treasurys. In general terms, yields should increase in line with maturity, giving rise to an upward-sloping, or normal, yield curve. The yield curve primarily illustrates the term structure of interest rates for standard U.S. government-issued securities. This is important to gauge the debt market's sentiments about economic risk.

US Treasury Yield Curve

The U.S. Treasury yield curve is considered the benchmark for the credit market because it reports the yields of risk-free fixed-income investments across a range of maturities. Yield curve rates are usually available at the U.S. Department of the Treasury's interest rate platform by 6 p.m. EST each trading day.

Banks and lenders use this benchmark in the credit market as a gauge for determining lending and savings rates. Yields along the U.S. Treasury yield curve are primarily affected by the U.S. Federal Reserve’s federal funds rate. Other yield curves can also be developed by comparing credit investments with similar risk characteristics.

Traditionally, the Treasury yield curve has most often been sloping upward. One basic explanation for this phenomenon is that investors demand higher interest rates for longer-term investments as compensation for investing their money in longer-duration investments.

The term structure of interest rates can have these shapes:

1. Upward Sloping or Normal Yield Curve

Long-term yields are higher than short-term yields. This is considered to be the "normal" slope of the yield curve and signals that the economy is expanding.

2. Downward Sloping or Inverted Yield Curve

Perhaps the most infamous, this indicates that short-term yields are higher than long-term yields. Dubbed an "inverted" yield curve, it has traditionally signified that the economy is in, or about to enter, a recession.

3. Flat Yield Curve

Here, there's very little variation between short and long-term yields. This signals that the market is unsure about the direction of the economy.

4. Steep Yield Curve

A steep yield curve occurs when long-term interest rates are significantly higher than short-term rates, resulting in an abruptly upward-sloping curve on a yield-to-maturity chart. This typically suggests there are expectations for strong economic growth, along with potential inflationary pressures (the more demand for goods as the economy grows, the more prices spike).

In such periods, investors demand higher yields on longer-term bonds to compensate for the increased risk of holding debt over extended periods.

5. Humped or Bell-Shaped Yield Curve

A humped or bell-shaped yield curve, also known as a barbell curve, is a less common configuration where medium-term yields are higher than both short-term and long-term yields. This unusual shape creates a "hump" in the middle of the curve, typically for bonds with maturities between two to five years. This pattern often reflects market uncertainty or conflicting economic signals—perhaps expectations of near-term interest rate increases followed by longer-term economic slowdown or deflation.

The humped yield curve can be mystifying for investors since it seems to disrupt traditional strategies based on normal or inverted curves. Financial analysts often interpret this shape as a transitional phase, potentially signaling a shift in economic conditions or monetary policy.

6. Double-Hump Yield Curve

A double-hump yield curve, also known as a camel curve, is relatively rare and typically reflects significant market uncertainty or diverging predictions about future economic conditions and interest rate movements.

The double-hump pattern might arise from a combination of short-term monetary policy actions, medium-term economic forecasts, and long-term structural factors. Interpreting a double-hump yield curve requires a subtle analysis of various economic indicators and market forces to understand why it's occurring.

Outlook for the Overall Credit Market

The term structure of interest rates and the direction of the yield curve can be used to judge the overall credit market environment. A flattening of the yield curve means longer-term rates are falling compared with short-term rates, which could have implications for a recession. When short-term rates begin to exceed long-term rates, the yield curve is inverted, and a recession is likely occurring or approaching.

When longer-term rates fall below shorter-term rates, the outlook for credit over the long term is weak. This is often consistent with a weak or recessionary economy. No doubt, understanding the term structure is crucial for predicting economic conditions. Monitoring shifts can help investors and policymakers anticipate and respond to economic downturns effectively.

For instance, before the 2008 financial crisis, an inverted yield curve in 2006 signaled the impending recession. Although various factors, such as international demand for U.S. Treasurys, can cause an inverted yield curve, it has historically served as a dependable signal of economic downturns in the U.S.

The Mystery of the 2020s' Treasury Yield Curve

However, there are live questions about whether it remains a dependable economic indicator. During the early 2020s, long-term yields fell below short-term yields, creating an inverted yield curve that is generally regarded as a harbinger of recession. Yet, it remained negative even in periods when the economy was growing, unemployment remained relatively low, and inflation—while hair-raising at times—was trending downward.

Former U.S. Federal Reserve Chair Janet Yellen (later U.S. Treasury secretary), seeing the yield curve head toward zero (it would be briefly negative a year later), said in late 2017 that she thought it was time to rethink the relationship between the term structure of interest rates and recessionary pressures. "There is a strong correlation historically between yield curve inversions and recessions, but let me emphasize that correlation is not causation," she said. "I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed."

Does an Inverted Yield Curve Still Signal a Recession?

She may have been right. In early 2020, the yield curve briefly inverted, signaling potential economic distress because of the COVID-19 pandemic. This was quickly followed, as we reported at the time, by a dramatic flattening as the Federal Reserve slashed interest rates to near zero and initiated extensive bond-buying programs to support the economy. The subsequent steepening of the yield curve in 2021 indicated growing optimism about economic recovery and rising inflation expectations since the economy was expected to rebound from the pandemic-induced recession.

However, 2022 was a year of calamities as inflation rose, supply chains knotted up, and the pandemic was still killing thousands each week, all prompting the Federal Reserve to tighten monetary policy. This caused short-term yields to rise faster than long-term yields, leading to a flatter yield curve with occasional inversions, particularly between the two-year and 10-year maturities. These inversions were closely watched as potential indicators of a future recession.

Throughout 2023, the yield curve remained volatile, with the Federal Reserve's rate hikes aimed at combating persistent inflation, resulting in further flattening and intermittent inversions. By the third quarter of 2024, it was still inverted, if flattening out a bit over 2023. Why was this so vexing during this period? This chart helps show why.

The Bottom Line

The term structure of interest rates is certainly crucial for assessing economic health. It illustrates interest rates of bonds with similar credit quality across different maturities, reflecting market expectations for future interest rates and monetary policy. A common yield curve comparison of U.S. Treasury debt (ranging from three months to thirty years) traditionally has been said to offer vital insights into economic trends and potential recessions, guiding investors and policymakers in their decisions.

However, analysts at the U.S. Federal Reserve and elsewhere began arguing more vocally in the late 2010s that previous correlations between inverted yield curves and recessionary periods were perhaps no longer relevant. As the major indicators of economic health in the U.S. in the 2020s occurred while the yield curve was still negative into the mid-2020s, economists and investors were left to knock on wood and hope for the best while analyzing the potential for turbulence ahead.