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The term structure of interest rates describes how yields on otherwise equivalent bonds vary with maturity, visualized as the yield curve. Three main theories explain its shape: the pure expectations theory (long rates equal the geometric average of expected future short rates), the liquidity preference theory (investors demand a term premium for longer maturities), and the market segmentation theory (supply and demand in each maturity segment independently determine yields). An inverted yield curve — where short-term rates exceed long-term rates — has historically been a reliable recession predictor. Forward rates, derived from spot rates, represent market expectations of future short-term rates.
Plot the current Treasury yield curve and identify its shape: normal (upward-sloping), flat, or inverted. Study historical inversions before the 2001 and 2008 recessions. Bootstrap forward rates from spot rates to extract implied expectations about future policy rates.
You already understand yield-to-maturity: for a single bond, it is the single discount rate that sets the present value of all cash flows equal to the current price. The term structure of interest rates steps back from individual bonds and asks: what pattern of yields do we observe across all maturities at a single point in time? Plot the YTM of risk-free (Treasury) bonds on the vertical axis and time to maturity on the horizontal axis, and you get the yield curve. In normal times it slopes upward — longer maturities yield more than shorter ones. But it can flatten, hump, or invert, and those shapes carry important information about the economy's expected future.
Three competing theories explain why the yield curve has the shape it does at any moment. The pure expectations theory says the long rate is the geometric average of expected future short rates: if 1-year rates are 3% today and expected to be 5% next year, the 2-year rate should be approximately 4%. No term premiums, no preferences — just expectations. The liquidity preference theory modifies this by noting that investors dislike locking up money for long periods and demand compensation for the uncertainty of holding long bonds. This adds a positive term premium to long rates, explaining why the curve usually slopes upward even when short rates are expected to stay flat. The market segmentation theory goes further: different investors (pension funds, banks, money market funds) operate in different maturity segments and do not easily substitute, so supply and demand in each segment independently influence yields.
Forward rates are the key analytical tool derived from spot rates. The 1-year forward rate one year from now is the rate implied by the relationship between the 1-year spot rate and the 2-year spot rate: it is the break-even rate that makes rolling over 1-year bonds equivalent to buying a 2-year bond today. Under pure expectations, forward rates equal expected future spot rates. With term premiums, forward rates exceed expected future short rates. This matters enormously for monetary policy analysis: when the central bank cuts short-term rates, the effect on long rates depends on how much of the long rate reflects expectations versus term premiums — a distinction that inflation and duration knowledge illuminates.
The inverted yield curve — where short-term rates exceed long-term rates — is the most watched shape because of its predictive record. It typically signals that the market expects future short rates to fall substantially, which happens when the market anticipates a recession and subsequent central bank easing. Every U.S. recession since the 1970s has been preceded by a yield curve inversion, often by 12–18 months. The mechanism is partly self-fulfilling: an inverted curve tightens bank lending (banks borrow short and lend long; when the spread inverts, lending becomes unprofitable) and signals economic stress that can dampen investment and consumption.