What Happens to Interest Rates When the Yield Curve Is Upward Sloping?

A yield curve is a plot of the value of interest rates for debt securities of various maturities at a given date. The graph of such a yield curve uses the vertical axis to reference interest rates and the horizontal axis to reference maturities. A typical yield curve is a graph of the different interest rates for U.S. Treasuries of various maturities, ranging from short-term Treasury bills to long-term Treasury notes and bonds. The shape of the yield curve differs over time, indicating changes in interest rates.

The yield curve is a daily plot, and investors use it to compare interest rates on Treasuries of different maturities. In general, the yield curve may be upward sloped, inverted or flat. The upward slope is considered a normal shape with short-term interest rates lower than long-term interest rates. However, the yield curve may be inverted under certain economic conditions, depicting higher interest rates on short-term securities and lower interest rates on long-term securities. A flat yield curve exists when the yield curve becomes less upward sloping or less inverted as economic conditions worsen or improve.

The yield curve can be upward sloping at a given time, as well as becoming upward sloping over time. An upward sloped yield curve indicates that investors expect the economy to improve in the future and demand higher interest rates on investments in securities of longer-term maturities for increased returns in a growing economy. Meanwhile, investors require less on shorter-term interest rates, as they perceive less risk of interest rates going down in the near future. A continually upward sloping yield curve over time reinforces investor expectations that increases in long-term interest rates may carry forward further.

Short-term interest rates normally fall when the yield curve is upward sloping with investors looking for higher long-term interest rates. Anticipating further increases in long-term interest rates as economic conditions become more favorable, investors would like to hold short-term securities that allow them to easily trade out of their positions for future purchases of long-term securities of higher interest rates. As a result of more investors buying short-term securities when the economy has yet to show further improvements, interest rates on short-term securities become lower as demanded.

Long-term interest rates rise simultaneously with the falling of the short-term interest rates when the yield curve is upward sloping. Purchasing long-term securities at the beginning of economic growth that potentially can lead to further increases in interest rates may lock investors into long-term securities at the current relatively lower rate level. Therefore, with fewer investors purchasing long-term securities while demanding higher interest rates, interest rates on long-term securities may trend even higher in the future. This may result in a yield curve that is likely to be continually upward sloping.