It is no secret that the bond market is the most important in the world. The well-oiled market machine burns debt as a fuel. But when you look inside, you realize that it is intermingled with yield rates, connecting the engine with its battery, the central bank.
Yield curves are a simple graphical representation of this relation. They are praised for simplicity, but more importantly, for their predictive qualities.
What is a Yield Curve?
In technical terms, a yield curve is a graphical representation of the difference in bond rates. It takes the bonds of the same credit quality but different maturity dates and plots a chart out of that difference.
In practical terms, a yield curve is a way to measure bond investor outlooks for the future.
When it comes to yield curves, there are 3 main factors:
- Economic growth: It steepens the curve and increases the yields. It is because the competition for capital is higher. Rampant economic growth also has a danger of increasing inflation due to rising aggregate demand.
- Inflation: Rising inflation leads to increased interest rates and decreasing purchasing power. Inflation decreases the demand for bonds, as fixed income is likely the worst investment in the inflationary environment. So, it raises the yields.
- Interest rates: Central banks control the interest rates and respond by raising or lowering them, according to the market conditions. Rising interest rates cause a lift of the short-term yield.
There are 5 types of yield curves, each one signaling different conditions on the market:
This is the most common and therefore considered a “normal” curve. By common sense, lenders who operate long term consider it riskier (odds of negative events rise with time). So, they mandate higher compensation in terms of higher interest rates. Yet, this rate doesn’t increase exponentially but follows gradual, diminishing returns.
The normal yield curve, source: author’s work
When the long-term yield falls below the short-term, the curve is inverted. It happens when the perception of the short-term risk is higher than the long-term risk.
The inverted yield curve is a leading indicator with a history of predicting market downturns.
The inverted yield curve, source: author’s work
The steep curve indicates a much faster rise in long-term yields. They look like a normal curve, except the difference between short-term and long-term yields is higher. They generally occur at the start of expansionary economic periods.
The steep yield curve, source: author’s work
A flat yield curve is a characteristic of a transitory period — between the normal and inverted or vice versa. A flat curve means there is the same yield between short-term and long-term bonds.
The flat yield curve, source: author’s work
A humped yield curve is rare, usually predicting an economic slowdown. It indicates that medium-term yields are greater than both short-term and long-term ones. Metaphorically speaking, it is like a bump on the road — not yet there but approaching quickly.
The humped yield curve, source: author’s work
What Does the Yield Curve Mean?
Since the U.S. is running the most important debt market in the world (U.S. treasuries), the yield curve between the short-term (3-month) and long-term (10-year) bonds has been a leading indicator of market downturns.
Naturally, long-term bond rates are higher than short-term rates because holding short-term debt is less risky. So, when the short-term bond rates fall and the long-term bond rates rise, investors are cautious about the short-term market prosperity.
Historically, inverted yield curves preceded every recession since 1956. The first inversion in recent years occurred in March 2019, and a market downturn soon followed.
There are 3 yield curve theories:
- Expectation theory: A theory that forward rates exclusively represent the expected future rates. The main weakness of this theory is not including the interest rate risks.
- Market Segmentation theory: A theory stating that long- and short-term interest rates are not related because they have different investors. Since each segment is a category on its own, the yields from one class should not predict the yields for another.
- Preferred Habitat theory: A hypothesis that certain bond investors prefer bonds with a particular maturity length over others. Therefore, they are willing to buy bonds outside their preferred range only if the risk premium is substantial. This theory differs from the market segmentation theory as it emphasizes short-term over yield, which means that investors model their risk based on time and not yield.
What Does the Yield Curve Tell You?
A yield curve can tell you the general sentiment of the debt market, the most important market in the world.
When the yield curve inverts, you should look for lower risk and possibly purchasing protection from the downturns.
Professional investors look at the yield curve for 4 significant reasons:
- Predicting interest rates: Central bank interest rates are the prime driver of the monetary policy. A steep curve might signal an interest rate rise, while an inverted curve for an interest rate fall.
- Financial sector profitability: Financial institutions like banks borrow through short-term and lend by long-term. So, their profits depend on the difference between those rates. A steep curve is positive, while an inverted curve is negative for the financial sector.
- Maturity-yield tradeoff: The slope of the curve dictates the tradeoff between the maturity (plotted on x) and the yield (plotted on y).
- Relative pricing of security: The curve can indicate whether a particular security is underpriced or overpriced. By comparing its yield against the curve, if the rate of return is below the curve, it means that the security is overpriced.
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One of the Best Market Barometers
Yield curves give a valuable insight into the market sentiment. First of all, they clarify the financial institutions’ approach to loan issuance. The steeper the curve, the more money they make through their lending operations, so the money supply will be more generous.
More importantly, they are a leading indicator of downturns. The inverted yield curve has been a reliable predictor of market crashes that followed after one to two years throughout history. While that sounds like a lot of time, consider the inverted yield curve like a canary in a coal mine. It gives a head start, but you have to start looking for an exit.
Frequently Asked Questions
What do yield curves tell us?
The yield curve is showing the markets’ appetite for risk in future economic activities.
Since yields change over time, the shape over the curve changes — giving us cues about the market sentiment. While there are few major curve types, the most famous one is the inverted yield curve. It signals that short-term risk is rising since investors are accepting lower yields for a long-term commitment. They are considered a leading indicator since market downturns and lower interests rates follow them within 9 to12 months.
How is yield calculated?
A simple formula calculates yield:
Yield = coupon amount / price
Since coupon amount is usually fixed and price varies due to supply/demand, this causes the yield to move daily. The Treasury updates this data at https://www.treasury.gov.