Ask a Fool: What Is the Yield Curve and Why Should Investors Care?

Q: I've heard economists on TV talking about the "flattening yield curve." What is the yield curve, and what does it mean if it's flattening?

A yield curve is the relationship between interest rates of bonds of different maturities that are the same in terms of credit quality.

The most frequently cited yield curve is that of U.S. Treasurys, using the three-month, two-year, five-year, 10-year, and 30-year Treasury securities.

So why should investors care? While it's not a perfect indicator all by itself, the shape of a yield curve can give you an idea of the future health of the economy. There are three main shapes a yield curve can take.

A normal yield curve is one where longer-maturity bonds have higher interest rates. This is generally a sign of a healthy, or expanding, economy.

A flat yield curve is one where long-term bonds have approximately the same yield as shorter-term bonds. This is often taken to be a sign of an upcoming transition from expansion to recession, or vice versa.

An inverted yield curve is one where shorter-maturity bonds have higher interest rates than longer-maturity ones. When the yield curve inverts, it is a pretty reliable indicator of an upcoming recession.

As of this writing, the yields of the five Treasury bonds I mentioned earlier are (from shortest to longest maturity) 1.984%, 2.595%, 2.759%, 2.888%, and 3.023%. This is still an example of a normal yield curve, but it has flattened significantly in recent months.