Term of the Day: Yield Curve
What is a Yield Curve?
According to Investopedia, “a Yield Curve is a line that polts the yields, or interest rates, of bonds that have equal credit uality but differing maturity dates.”
- It is a mathematical and statistical measure of the difference in the yield of long term and short term fixed income securities
- Primarily in context of the United States of America bond market, particularly the US Treasury Bills
Most commonly, it is taken as the difference between the yields of the 10 year and the 3 month Treasury Bill Rate.
There are three types of Yield Curves:
- Normal, Upwards Sloping Yield Curve
- Inverted, Downward Sloping Yield Curve
- Flat Yield Curve
- Steep Yield Curve
Why is it so important?
The slope of this curve is shown to have correlation with the stage of the business cycle in an economy. It is essentially a predictor of the state of the economy, depicting the institutional forecasts on outlook and growth.
In general, long term debt instruments carry greater uncertainity of future events, implying that, even with the same credit profile, the investor bears a greater amount of risk. When institutions believe that the economy is going too well, the yield curve usually reflects this structure. Additionally but less prominently, the yield curve may also be highly positive during periods of prolonged growth, where the short term rates are low, but investors expect that the Federal Reserve would raise interest rates in the future.
On the other hand, the abnormal inverted yield curve is a concerning development that is shown to precede many recessions in the United States as well as Europe. The table below shows how, as the yield curve inverts, and short term securities yield a higher coupon than long term securities, the chance of a recession increases drastically.
The reason for the inversion of the yield curve and its relation to recessaions is slightly complex. Essentially, during recessions, in order to stimulate economic activity, the Federal Researve usually aims to lower interest rates through its various tools, such as in 2008 and 2020. Thus, when the present economic scenario is not necessarily a recession, but insitutions have a negative and recessionary outlook, it means that they feel interest rates would fall in the future. In such a circumstance, whle short term Treasury Bills would remain largely unaffected, the long term Treasury Bills would decrease, creating the inversion.
Sources
- https://www.investopedia.com/terms/y/yieldcurve.asp
- https://www.fidelity.com/learning-center/investment-products/fixed-income-bonds/bond-yield-curve
- https://www.bis.org/publ/confp02n.pdf
- https://www.investopedia.com/terms/i/invertedyieldcurve.asp
- NEW_yieldcurve_hero_june2023-cropped-2–770x583.png
- YieldCurve2–362f5c4053d34d7397fa925c602f1d15.png