The yield curve: how does it work?
The yield curve is the name given to the graphical representation of yields of similar securities of different maturities. For government bonds, it shows how much it costs for the government to borrow money for different periods of time (i.e. how much it cost to borrow money for 3 months, 6 months, 1 year etc etc). These curves hold a great deal of information about how inflation, output and public spending are expected to evolve in the future.
What gives the yield curve this fascinating quality is its ability to act as the aggregate mouthpiece for a host of financiers, a sort of sentiment aggregator that twists and curves as investors bid for securities of different maturities. Yields curves—generally for treasuries but also for corporate bonds, interest rate swaps, and other securities of varying maturity—display the sentiments of the financial collective.
Essentially, a normal yield curve will take on the form of an upward sloping curve, indicating that yields in the short run are smaller than those for longer term securities (ie: the return on a 3-month T-bill is lower than the return on a 10-year security). An inverted yield curve arises when long term yields are less than short term yields, thus giving the curve a generally negative slope.
The chart above shows daily closing yields for US treasuries: the turquoise line best represents a normal yield curve while the purple and blue lines represent (more or less) a flat yield curve and inverted yield curve respectively.
Research shows that a flattening of the yield curve, or an inversion of the curve, generally leads to a downturn in output and inflation. This conclusion is reflected in the chart. The flatter yield curves are taken from early 2000 and later in the same year—approximately 1 year and 4 months before the recession triggered by the dot-com bubble began in the US: their shape indicates that trouble could be on the way. Meanwhile, the green line is taken several months after the start of that recession, and is closer to what ‘normal curve’ should be, where markets are compensated by higher yields for risk associated with longer maturities. The upward slope of the green line is more indicative a well-functioning financial system – full steam ahead.
Let’s get technical…
Many factors can play a role in the cost of government debt and there does not appear to be any hard and fast textbook explanation for why the relationship between the slope of the yield curve and future output exists, and indeed there are many reasons why a yield curve might lose its normal shape and take on a form which investors perceive as uncanny or perplexing. One simple and popular explanation relies on the assumption that the curve represents a manifestation of aggregate investor sentiments responding to anticipated monetary policy decisions made by the Central Bank. The increase of short term policy rates (such as the Federal Funds Rate) is generally seen as a portent for decreasing economic activity. Policy rates are associated with discount rates on short term government debt, since the two essentially are substitutes for short-term risk-free debt. Therefore, as a Central Bank tightening cycle takes effect, the return on short term government debt would increase. Economic contraction are associated with higher policy rates, therefore also with higher short term yields on government debt.
Expectation hypothesis
According to what is known to economist as the expectation hypothesis (EH), long term interest rates are determined by the average of short term rates (ie: the rate of return for a 10 year bond should be determined by the expected short rates of return in each of the 10 years.) According to the EH, yields on 10 year bonds should be proportionally less than the yields on short term bonds if short term rates decrease over the 10 years of the bond’s maturity, perhaps because the Central Bank is lowering rates in order to stimulate a depressed economy. Using the EH in this way supports the idea that small yields in the long term are associated with an economic contraction in the short to medium term.
Of course monetary policy isn’t the only factor behind the twisting of the yield curve. Different maturities are preferred by different investors. More recently, buyers have had a particular appetite for long term US debt, resulting in disappearing long term yields, and a flattening of the curve, which did not have a clear link with an economic downturn.
Beyond the U.S.
Although substantial attention has been paid to the yield curve of US treasuries and those of other advanced economies, relatively little is known about the workings of those in emerging markets. Emerging markets suffer from a lack of data which makes studying these curves cumbersome. In many cases, these economies don’t have markets in which investors set the price of government debt, instead the market for such debt is more controlled and therefore the yield curves contain less market sentiment and more central planning. This is changing however: developing economies are building more advanced financial architectures—and better statistics—through which similar analysis can be conducted.
Investors’ sentiment about the future of the economy is captured by this modest curve, making the yield curve a closely watched leading indicator of economic activity. This is one reason why FocusEconomics tracks the evolution of 10-year and 3-month yields in its Consensus Forecast reports.