Steep Yield Curve

Definition

The financial investing term steep yield curve refers to a rapidly upward sloping line plot used to illustrate the difference between short and long-term debt instruments at various maturities.  A steep yield curve is a variation of the normal yield curve, possessing the same basic properties; whereby the interest rates paid on securities with shorter maturities is lower than rates paid on debt with longer maturities.

Explanation

Also known as the term structure of interest rates, yield curves are typically used depict the relationship between interest rates and the time to maturity of a debt security such as a bond.  The shape of the curve provides the analyst-investor with insights into the future expectations for interest rates as well as possible increases or decreases in macroeconomic activity.  Yield curves are simple line plots showing the term, or maturity, on the x-axis (horizontal axis) and the corresponding rate of interest, or yield, on the y-axis (vertical axis).  When plotting a yield curve, the securities should be of similar, if not identical, credit quality.

As the illustration below demonstrates, a steep yield curve has a positive slope that is extremely asymmetrical; the returns on near term maturities rise very rapidly, and then increase at a progressively slower rate.  Also known as a steepening yield curve, this type of plot occurs when there is a relatively large difference between short and mid-term bonds.

When a plot of debt issued by the U.S. Treasury Department results in this type of curve, it's normally interpreted as a signal the United States is about to enter a period of rapidly increasing economic activity or the end of a recession.

There are a couple of explanations for this type of curve:

  • Near-Term Interest Rates:  investors anticipate a relatively rapid increase in rates, and are unwilling to invest in bonds with long maturities.  This results in a sharp decrease in demand for mid and long-term bonds, which subsequently increases yields.
  • Long-Term Credit:  borrowers believe interest rates will be higher in the future, thereby driving up their demand for long-term credit.  This increase in demand for long-term credit results in a sharp rise in long-term interest rates.

Example

The following illustration demonstrates the shape of a normal versus steep yield curve.

Steep Yield Curve

Related Terms

yield curve, normal yield curve, inverted yield curve, flattened yield curve, humped yield curve, backwardation, contango