A yield curve is a chart showing interest rates versus time. In the bond market, the time spans from overnight to 30 year maturity dates. There are maturity dates in-between that mark short term (0-5 years), mid-term (5 to 10 years) and long term (10 to 30 years). See the picture below. What Drives the Price of a Bond? The shortest maturity date (overnight) is determined by a central bank. The Bank of Canada has meetings approximately every 6 weeks to set the interest rate. They are setting the overnight interest rate which is the shortest rate on this chart. The remaining interest rates are set by the bond market which is driven by supply and demand for debt. A government bond is a debt whereby the government is the borrower and issuer and the investor is the lender. The government would pay interest to whoever buys the bond – or agrees to lend money to them. If there is more demand for debt, the price of the debt would rise, meaning that the yield or return would fall. If there is less demand for debt, the price of the debt would fall and the yield or return would rise. Why is this? The price of a bond is determined by how much interest it pays out throughout its life. The interest payouts are fixed (this is where the term fixed income comes from) when the bond or debt is created. Should the market interest rate change, the interest payments are still the same for the bond in question. The only way this existing debt can adjust its price to a different interest rate is by changing the price of the bond. The demand for debt will also be determined by time to maturity. A short term bond is considered debt needed for current needs, like cash flow for a business. Longer term debt is for longer term borrowing needs like larger capital expenditures. Types of Yield Curves A normal yield curve usually has lower rates for shorter times to maturity, with the interest rate rising with longer maturity dates. A shorter time period is considered less risk because there is less time for a bond to not pay its interest (default) or have the supply / demand change quickly. Embedded in the interest rate is also the inflation rate. If you are lending money, you want to get paid back the principle (what you lent), enough interest to make it worthwhile, and the rate of inflation to cover the fact that the money you receive at the end of the loan is worth less than when you lent it out at the beginning of the loan. A flat yield curve is saying that the risk is actually equal over the whole spectrum of interest rates. An inverted yield curve is saying that there is more risk in the short term either of default, higher inflation or of lack of supply compared to the long term. Many people use the inverted yield curve to predict a recession because if demand is less in the short term than in the long term, business conditions are worse in the short term meaning that fewer people want to borrow money if they can’t pay it back.