The yield curve, according to academic and empirical studies, has a direct influence on the state of the economy. For instance, a positive yield curve is correlated with a strong economy and growth expansion, while a negative yield curve is tied to a weak economy with little to no growth expansion.
As mentioned before, the yield curve is so important that the majority of economists and market analysts use the yield curve within their analysis.
The relationship between the yield curves and economic conditions can be easily explained. In a strong economy and growth expansion, the demand for capital is increased which increasing borrowing. This demand will bring yields higher across all debt instruments but more so in government debt. Conversely, weak economies and little growth expansion decreases the demand for borrowing and lending, thus it brings down yields – this can be seen in many developed economies today.
The yield curve is also used as a leading indicator as it is forward looking. A positive yield curve indicates that yields and growth expansion will be higher into the future. A negative yield curve suggests that there will be lower to no growth expansion and potential contraction in the economy.
This also effects financial institutions greatly. Typically, banks will borrow using the short-term interest rate and lend using the long-term interest rate. So, banks borrow at a lower cost and lend at the higher interest rate, and this is where lending is profitable for banks. However, when the yield curve is negative or flat, banks will not lend to consumers because it is less profitable and creates a greater risk for bad loans. The shrinking credit will greatly effect the economy negatively.
However, the yield curve could create unfamiliar and rare curves that do not confirm to the positive, flat and negative paradigm. These type of curves suggest that their are imbalances in demand and supply along the yield curve or that the market is expecting volatility in future interest rates.
Yield curves part three will explain how yield curves are formed and what exactly a flat, or neutral , yield curve is.