Interest Rates, Yield Curves, and Credit Spreads

Quick Answer

Interest rates and bond prices move inversely: rates up, prices down. A yield curve plots yields across maturities; normal slopes up, inverted slopes down (the most reliable recession signal), flat is roughly level, and steep signals strong expected growth. Credit spreads, the extra yield over Treasuries, narrow in expansions and widen in recessions.

Now that you understand what drives rate changes (inflation, Fed policy), you can interpret yield curves and credit spreads as the market's own read on where the cycle is headed.

Why Do Bond Prices Move Opposite to Rates?

Interest rates represent the cost of borrowing money.

The Fed influences short-term rates through monetary policy; market forces drive long-term rates.

Interest rates and bond prices have an inverse relationship.

When interest rates rise:

Bond prices fall as yields rise.

Borrowing costs increase.

Economic activity slows.

When interest rates fall:

Bond prices rise as yields fall.

Borrowing costs decrease.

Economic activity increases.

Why does this happen? Imagine you own a bond paying 3 percent interest. If new bonds start paying 5 percent, nobody wants your 3 percent bond at full price anymore. You would have to sell it at a discount. That is why rising rates push bond prices down.

Which Moves More: Rates or Prices?

Short-term and long-term rates do not move the same way, and neither do short-term and long-term bond prices. These are two separate comparisons, easy to mix up.

Short-term rates are more volatile than long-term rates. The Fed's tools act directly on the short end of the curve, so short-term rates swing more often and more sharply as policy shifts. Long-term rates reflect the market's average expectation for rates over many years, so they move more slowly.

Long-term bond prices react more to a given rate change than short-term bond prices. A bond's cash flows are locked in for its full term, so the longer that term, the more years of cash flows get repriced when rates move. This is the idea behind duration, covered in depth in Fixed Income Characteristics.

Exam Tip: Gotchas

Rate volatility and price volatility point to opposite ends of the curve. Short-term rates move around more, but it is long-term bond prices that move around more when rates change. A "more volatile rate" and a "more volatile price" are not describing the same maturity.

What Do the Different Yield Curve Shapes Signal?

A yield curve plots interest rates (yields) of bonds with equal credit quality across different maturities. Most commonly plotted using U.S. Treasury securities (risk-free benchmark).

Normal (upward sloping): Shape upward sloping. Long-term greater than short-term. Signals healthy economic growth expected.

Inverted (downward sloping): Shape downward sloping. Short-term greater than long-term. Signals recession signal; historically reliable predictor.

Flat: Shape level. Rates approximately equal. Signals economic uncertainty; transition period.

Steep: Shape sharply upward. Long-term much greater than short-term. Signals strong economic expansion expected; often seen at beginning of recovery.

Humped: Shape rises then falls. Medium-term highest. Signals uncertainty about the medium term; often read as a transition toward inversion.

How Does the Yield Curve Relate to the Business Cycle?

Steep curve: typically found at the bottom of the cycle (beginning of expansion); short-term rates are low (Fed stimulus).

Flattening curve: occurs during expansion as the Fed raises short-term rates.

Inverted curve: typically precedes a recession; short-term rates exceed long-term rates.

Re-steepening: occurs during contraction as the Fed cuts short-term rates.

The slope of the curve is the spread between a long-term and a short-term yield (long-term minus short-term). Flattening means that spread narrows, and steepening means it widens.

Example: a 2-year yield of 2.0 percent and a 10-year yield of 5.0 percent give a spread of 300 basis points. If the 2-year yield rises to 4.5 percent and the 10-year stays at 5.0 percent, the spread narrows to 50 basis points, so the curve flattens. It inverts only if the 2-year yield rises above the 10-year yield.

Exam Tip: Gotchas

An inverted yield curve, short-term rates above long-term rates, is the most reliable recession predictor tested on the exam. It is a warning sign, not a certainty.

What Do Credit Spreads Signal?

Credit spread: the difference in yield between a corporate bond and a comparable-maturity Treasury security (the risk-free benchmark).

Represents the additional yield investors demand for taking on credit (default) risk.

Expressed in basis points (1 basis point = 0.01 percent).

Expansion: Spreads narrow (confidence is high, default risk perceived as low).

Recession: Spreads widen (uncertainty rises, default risk perceived as higher).

Widening spreads indicate increasing concern about credit quality and economic weakness.

Narrowing spreads indicate improving confidence in credit quality and economic strength.

Lower-rated bonds (high yield/junk) have the widest credit spreads.

Exam Tip: Gotchas

Credit spreads widen during recessions (more risk) and narrow during expansions (less risk). Do not confuse the yield curve (plots maturities for one credit quality) with credit spreads (compares credit qualities at one maturity).

What Should You Check on Exam Day?

Know the inverse relationship between rates and bond prices, and be able to explain why in your own words.

Keep rate volatility (short end moves more) separate from price volatility (long end moves more).

Match each yield curve shape (normal, inverted, flat, steep) to its signal and its typical place in the business cycle.

Remember an inverted curve is the exam's most reliable recession predictor.

Know that credit spreads narrow in expansions and widen in recessions, and that lower-rated bonds carry the widest spreads.

Additional Details

Published: 2026-11-02T21:59:23.883Z