The yield curve

In simple terms

Bonds of the same borrower can have very different maturities: a few months, two years, ten years, thirty years. Plot their yields against their maturities, and you get the yield curve. For India, the curve usually refers to central government bonds and treasury bills.

Its shape carries information about what investors expect for interest rates, inflation and growth.

Reading a curve

The spread between a long and a short yield summarises the slope. Spreads are often quoted in basis points; one basis point is one-hundredth of a percentage point, so 2.0 points is 200 basis points.

Why the curve usually slopes upward

Two forces shape the curve:

1. Expectations of future short-term rates. A 5-year yield reflects, roughly, the average short-term rate investors expect over five years. If they expect the RBI to raise rates, longer yields sit higher.
2. A term premium. Lending for longer exposes investors to more uncertainty about inflation and rates, and bigger price swings, as the bond yields lesson explains. They usually want extra return for that.

Supply and demand matter too: heavy government borrowing at long maturities can lift long yields, and institutions such as insurers and pension funds that need long bonds can push them down.

Flat and inverted curves

A flat curve means short and long yields are similar. It often appears when the central bank has raised short-term rates to fight inflation and investors expect rates to stop rising.

An inverted curve, with short yields above long ones, usually means investors expect short-term rates to fall in future. That often happens when they expect growth and inflation to weaken and the central bank to cut rates.

The curve as a signal

In some economies, notably the United States, inverted curves have come before many recessions over past decades. That has made the curve a popular warning sign, as the economic cycles lesson describes. But:

• The delay has varied widely, from months to a couple of years.
• There have been false signals: inversions not followed by recessions.
• Markets can rise for a long time after an inversion.
• The curve can be distorted by central bank bond buying, liquidity conditions, government borrowing patterns and regulations that require some institutions to hold bonds.

In India, the curve is strongly influenced by RBI liquidity operations and the government's borrowing plans, so its signals need careful interpretation alongside other indicators.

What the curve means for investors

• Banks borrow short and lend longer, so a steeper curve can help their margins, and a flat or inverted one can squeeze them.
• Debt fund investors face different risks at different points of the curve: long bonds swing more when yields change.
• Equity investors can use the curve as one input about the cycle, not as a market timer.

Why it matters

The yield curve condenses the bond market's expectations about rates, inflation and growth into one picture. Reading it helps you understand policy news, bank profitability and the debate about where the economy is heading.

Limitations

Expectations embedded in the curve are often wrong. Term premiums change over time and cannot be observed directly. Different spreads, such as 10 years minus 2 years or minus 3 months, can give different signals. The historical record in any one country covers a limited number of cycles.

Common mistakes

• Treating an inversion as a precise recession forecast.
• Selling everything on an inversion without other evidence.
• Ignoring distortions from central bank operations and government borrowing.
• Confusing the level of yields with the slope.

Try it yourself

1. Find yields on Indian government securities at 3 months, 2 years, 5 years and 10 years and sketch the curve.
2. Calculate the spread between the 10-year and the 3-month yield in basis points.
3. Check how the curve's slope has changed over the past year and relate it to RBI policy decisions.