What Is a Yield Curve and How Can It Help You Make Money in Forex?

When investing in Forex, understanding yield curves will help an investor make money and avoid losing it. A yield curve is, technically speaking, a line on a graph that plots interest rates at a set point in time. The interest rate reflects bond interest rates.

Think of bonds as loans. Every loan has two parties involved: a borrower and a lender. The bond holder is the lender and the bond issuer is the borrower. The yield is the interest rate that the borrower (the bond issuer) pays to the bond holder (the lender). Bonds are debt instruments that can have short and long maturities.

Maturity refers to the amount of time that passes before the total interest, promised by the bond issuer, is paid to the bond holder.

By plotting bond interest rates on a graph, Forex investors hope to gain insight as to where future bond interest rates will head. Using this information, Forex traders can then make decisions about how to buy and sell currencies for profit.

The most frequently reported yield curve compares the three-month, two-year, and 30-year US Treasury debt. This yield curve is used as a sort of benchmark for other debt in the market like mortgage interest rates and bank lending rates.

Yield curves are also used to predict economic output and growth. There are three basic types of yield curves. The first is a normal yield curve. The second is an inverted yield curve, and the last is a flat yield curve.

A normal yield curve slopes upward and will show that shorter-term bonds pay a lower interest rate (yield) than longer-term bonds. This makes sense since long-term bonds must factor in the effects of inflation and other risks of holding bonds over a long period of time.

An inverted yield curve is one in which short-term interest rates rise above long-term interest rates. In this scenario, the market is predicting that the economy does not look good in the short-term. Inverted yield curves often forecast a recession in the near-term.

A flat yield curve is also indicative of an economic transition. What that transition leads to depends on many factors. Generally, the flat curve indicates that long-term rates are going to be the same or very similar to short-term rates. For borrowers, this can be good — especially for those borrowing at a variable rate. For investors, it signals that there is not much money to be made by buying long-term bonds.

For normal and inverted yield curves, the degree of the slope is also indicative of where markets are headed and signal the degree of volatility in the marketplace. If a normal yield curve has a very steep slope, it indicates strong economic growth with low volatility. When an inverted yield curve is very steep, it indicates a recession and higher volatility in the market.

How to Use This Information

Understanding the yield curve can drive investor behavior and allow profitable investment decisions. For example, on a "quiet" day when the USD/JPY pair is trading with subdued momentum, the bond yield can signal whether to take a long or short position. In essence, the yield curve tells Forex investors what is about to happen in the market.

However, it is not very useful to look at one yield curve in isolation. In forex, currencies are traded in pairs, so looking at the yield curves of both currencies is necessary. In this example, an investor would study the yield curve of the USA and Japan.

If the yield curve of the USD rises sharply, while the yen stays flat, it would suggest that the USD/JPY would appreciate. If a trader traded on this information, he would make money by investing in the USD/JPY.

by Elizabeth Goldman

Elizabeth Goldman is a freelance finance writer on behalf of Everest FX where you can learn Forex trading online and find Forex bonus points. The views and opinions expressed are of the writer and do not necessarily represent Everest FX.