Yield curve analysis is simplified into the shape and slope of the curve when Treasury security yields are plotted against time to maturity. Three yield curve shapes are commonly discussed.
Normal Yield Curve: A normal shaped yield curve has interest rates low at the short end of the curve and gradually increasing to the highest rates at the 30-year end of the curve. This is the most common shape for the curve and makes logical sense. Investors usually expect to be paid a higher rate of interest for locking their money up for a longer period of time. Short maturity securities provide liquidity in exchange for lower rates. The yield curve pictured above is a normal curve. The slope of a normal yield curve, flatter or steeper, can be analyzed as to market expectations for economic growth. Higher growth is expected to lead to inflation, so if high growth is forecast, longer rates will be significantly higher than short rates. Moderate growth does not have as much inflation risk, so longer rates won't be as high, resulting in a shallower yield curve slope.
Inverted Yield Curve: When short term rates are higher than long term rates, the yield curve is said to be inverted. Instead of sloping up, the curve slopes down. Rates at the short end of the curve are very high as the Fed tries to slow inflation by increasing short term rates. Long rates are lower than short rate because long term bond investors expect the Fed actions to reduce inflation and interest rates will eventually decline. Long bond investors are happy to lock in rates which are lower than the short rates, but historically high. A recent inverted yield curve occurred in August 2000 (see image) with the 3-month Treasury bill rate at 6.3 percent and the 10 and 30-year rates near 5.7 percent. Probably the most famous inverted curve occurred in 1981, when short term rates were over 15 percent and long bond rates were around 12 percent. An inverted yield curve is viewed as an indicator of a pending economic recession.
Flat Yield Curve: A flat yield curve is when rates are pretty much at the same level from short to long maturities. The curve usually flattens when it is transitioning from normal to inverted or inverted to normal.