A "normal" yield curve, post 1940, is when yields rise as maturity lengthens (i.e., the slope of the yield curve is positive). This positive slope reflects investor expectations for the economy to grow in the future, and for this growth to be associated with a greater expectation that inflation will rise in the future rather than fall. This expectation of higher inflation leads to expectations that the Federal Reserve will tighten monetary policy by raising short term interest rates in the future to slow economic growth and dampen inflationary pressure. It also creates a need for a risk premium associated with the uncertainty about the future rate of inflation and the risk this poses to the future value of cash flows. Investors price these risks into the yield curve by demanding higher yields for maturities further into the future. Below is an example of a normal, positively sloped US Treasury yield curve.
The "steep" yield curve is when the spread between the 20-year and 3-month yields is larger than normal. Historically, the 20-year Treasury yield has averaged approximately two percentage points above that of the three-month Treasury bill. In situations when this gap increases the economy is expected to improve quickly in the future. This type of curve can be seen at the beginning of an economic expansion, or after the end of a recession. Below is an example of a steep yield curve. Note that as of May 19, 2009 the US bond market thinks that the US economy is ready to grow again.
A "flat" yield curve is observed when all maturities have similar yields. A flat curve sends a signal of uncertainty in the economy. Below is an example of a flat yield curve.
An "inverted" yield curve occurs when long-term yields fall below short-term yields. Under unusual circumstances, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. An inverted curve has indicated a worsening economic situation in the future 5 out of 6 times since 1970. The New York Federal Reserve regards it as a valuable forecasting tool in predicting recessions two to six quarters ahead. In addition to potentially signaling an economic decline, inverted yield curves also imply that the market believes inflation will remain low. This is because, even if there is a recession, a low bond yield will still be offset by low inflation. Below is an example of an inverted yield curve where we can see that the bond market was predicting a future recession in late February, 2007.