Normal Yield Curve

Updated on May 2, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Normal Yield Curve?

A normal Yield Curve or Positive Yield Curve arises when longer maturity debt instruments offer higher yield as compared to shorter maturity debt instruments carrying similar credit risks and credit quality. The yield curve is positive (upward sloping) because investors demand more money for locking up their money for a higher period.

Key Takeaways

  • The normal yield curve emerges when longer-term debt offers higher yields than shorter-term debt with comparable credit risks. 
  • This happens because investors demand more compensation for locking in their money for extended periods. Consequently, the yield curve slopes upward, reflecting this trend.
  • The normal yield curve has implications for the present and future strength of the economy. It provides insights into the potential direction of the economy in the future, offering early indications of economic shifts. Ongoing shifts influence the curve’s changes in the broader market environment.
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Graphical Presentation of Normal Yield Curve

The yield curveYield CurveThe Yield Curve Slope is used to estimate the interest rates and changes in economic activities. It is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis).read more is created below on a graph by plotting yield on the vertical axis and time to maturity on the horizontal axis. When the curve is normal, the highest point is on the right.

Normal Yield Curve Graph

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Different Theories of Interest Rates

Theories of Interest Rates

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#1 – Expectation Theory

Expectation theory says that long-term interest rates should reflect expected future short-term rates. It argues that forward interest rates corresponding to certain future periods must be equal to future zero interest rates of that period.

If the 1-year rate today is at 1%, and the 2-year rate is 2%, then the one-year rate after one year (1yr forward rateForward RateThe forward rate refers to the expected yield or interest rate on a future bond or Forex investment or even loans/debts.read more) is around 3% [1.02^2/1.01^1].

#2 – Market Segmentation Theory

There is no relationship between short-term, medium-term, and long-term interest rates. The interest rate at a particular segment is determined by demand and supply in the bond market of that segment. Under the theory, a major investment such as a large pension fundLarge Pension FundA pension fund refers to any plan or scheme set up by an employer which generates regular income for employees after their retirement. This pooled contribution from the pension plan is invested conservatively in government securities, blue-chip stocks, and investment-grade bonds to ensure that it generates sufficient returns.read more invests in a bond of a certain maturity and does not readily switch from one maturity to another.

#3 – Liquidity Preference Theory

Investor prefers to preserve liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more and invest funds for a short period. On the other hand, Borrowers prefer to borrow at fixed rates for long periods of time. This leads to a situation where the forward rate is greater than the expected future zero rates. This theory is consistent with the empirical result that the yield curve tends to be more upward-sloping than downward-sloping.

Changes or Shifts in Normal Yield Curve

  1. Parallel Shifts – Parallel shift in the yield curve occurs if the yields across all the maturity horizons change (increase or decrease) by the same magnitude and similar direction. It represents when a general level of interest rate changes in an economy.
  2. Non Parallel Shifts – When the yield across different maturity horizons changes at a different level in both magnitude and direction.

Importance

Influence

Key Points to Remember

Frequently Asked Questions (FAQs)

1. Is the normal yield curve concave or convex?

The normal yield curve is typically upward-sloping and convex. This means that as the maturity of bonds increases, their yields also increase. It reflects the expectation of higher interest rates in the future, compensating investors for the extended period they hold bonds.

2. What are the applications of a normal yield curve? 

The normal yield curve has several applications:
Economic Outlook: An upward-sloping curve suggests a growing economy with rising interest rates.
Investment Strategy: Investors may choose longer-term bonds for higher yields.
Borrowing and Lending: Firms might borrow short-term and long-term to benefit from the yield spread.
Policy Decisions: Central banks monitor yield curves to assess economic conditions and guide monetary policy.

3. What is a normal vs. inverted yield curve? 

A normal yield curve has an upward slope, indicating higher yields for longer-term bonds. This is typical in healthy economies. An inverted yield curve, on the other hand, slopes downward, with shorter-term yields higher than longer-term yields. It often indicates economic uncertainty and can signal an impending recession. Economists, investors, and policymakers closely watch the relationship between short- and long-term yields for insights into the economy’s health.

Recommended Articles

This has been a guide to what is a normal yield curve. Here we discuss different theories of interest rate, changes, or shifts in the normal yield curve, its influence, and its importance with a detailed explanation. You can learn more about fixed income from the following articles –

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