Introduction
Normal yield curve refers to a yield curve consisting of short-term debt instruments having a lower yield rather than long-term debt instruments bearing the same credit quality. The short-term debt makes the yield curve slope upward. The yield curve shape is a positive yield curve and indicates the trend for future short-term interest rates.
Understanding Normal Yield Curve
In case there is an upward slope yield curve, the curve indicates an expectation of higher interest rates across financial markets. A downward slope of the yield curve, however, indicates an expectation of lower interest rates. In general, people consider the yield curve as normal since the market's normal expectation is more compensation for higher risk.
In the case of long-term bonds, the bonds carry exposure to high risk due to factors, such as changes in the interest rates, thereby increasing exposure to defaults. Also, long-term investment hampers one's ability to use the money in any other way. However, the investor gets compensation for short term opportunity losses by way of increase in the time value of money component in the yield.
In the case of a normal yield curve, the slope generally moves upward representing the higher yields in case of long-term investments. The higher yields compensate for the incremental risk normally involved in long-term investments. The shape represents normal since it is positive and also represents the shift in yields for the extended maturity dates.
The yield curve broadly represents the shifts in interest rates of particular security linked with the time until maturity. The yield curve is not a product of a single entity or the government of a country. Instead, the yield curve represents the feel and expectation of the market on the interest rates at a point in time.
Conclusion
The slope of a yield curve and its direction indicates the current situation and possible direction of an economy. The other types of yield curves can be flat or inverted. The flat curve shows that the returns on short and long-term investments are the same.
A flat curve appears when an economy approaches a recessionary period as fearful investors move their money into low-risk options, increasing prices and lowering overall yield.
