The yield curve is the graphical representation of the relationship between sovereign yields (i.e. the interest rates on sovereign bonds) and their maturity.
Among other things, the yield curve shows economic agents’ expectations about future interest rate developments. It also includes the compensation premia for the risk associated with future movements in those rates and the possibility of a sovereign default.
The yield curve is particularly useful to determine the financing conditions of a country’s economic agents. Besides directly determining the cost at which a country is financed on the capital market, the yield curve also has a significant impact on such costs for other bond issuers, including financial institutions and large corporations. It also influences the financing costs of households and firms with no access to bond markets (the vast majority in Spain), as the yield curve is often taken as reference for fixed-rate loans (see What are reference interest rates?).
Lastly, the yield curve provides information on investors’ expectations about the future path of short-term interest rates. Interest rates at a specific horizon (two years, for example) depend largely on the average expected short-term interest rate over that timeframe, which is known as the “expectation component”. However, the yield curve is not only shaped by the expectation component, but also by the “term premia” that compensate investors for the risk associated with changes in the bonds’ value until maturity. In fact, the yield curve will normally have an upward slope, reflecting that bonds tend to have higher yields as their term increases, since a longer duration entails greater risk of the bond losing value over time. This higher future risk is normally rewarded with a higher yield. Conversely, an inverted curve (where yields are greater for short-term bonds than for long-term bonds) may indicate that economic activity is expected to weaken in the future and inflation is expected to decrease. This is because, should such a scenario materialise, investors assume that the central bank would react by cutting short-term interest rates, and this reduces long-term interest rates through the expectation component.