Term Structure Of Interest Rates

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 a yield curve, and it plays a central role in an economy. The term structure reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions.

In general terms, yields increase in line with maturity, giving rise to an upward-sloping yield curve or a normal yield curve. The yield curve is primarily used to illustrate the term structure of interest rates for standard U.S. government-issued securities. The U.S. Treasury yield curve includes the three-month, two-year, five-year and 30-year issued U.S. Treasury debt.

This yield curve is considered the benchmark for the credit market, as it reports the yields of risk-free fixed income investments across a range of maturities. In the credit market, banks and lenders use this benchmark as a gauge for determining lending and savings rates. Yields along the U.S. Treasury yield curve are primarily influenced by the Federal Reserve’s federal funds rate. Other yield curves can also be developed based upon a comparison of credit investments with similar risk characteristics.

Most often, the Treasury yield curve is upward-sloping. 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. Occasionally, long-term yields may fall below short-term yields, creating an inverted yield curve that is generally regarded as a harbinger of recession.

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 in comparison to 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, which is defined by two consecutive periods of negative growth in the gross domestic product (GDP). While other factors including foreign demand for U.S. Treasuries can also influence an inverted yield curve, historically an inverted yield curve has been an indicator in the United States of a recession.