Interest rates for the bonds depend on the maturity and, thus, behave quite differently from other interest rates. A yield curve is used to portray this behavior of bonds’ interest rate. So, a yield curve is a graph that plots the interest rates at a point of time of the bonds with the same credit quality but varying maturity dates. It is also known as the term structure of interest rates.
The most commonly used yield curve compares three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. It serves as a benchmark for other interest rates, like bank rates, mortgage rates, etc. The information on the yield curve rates is easily available on Treasury’s interest rate websites on a daily basis.
Types of Yield Curve
There are three types of yield curves shapes:
In a normal-shaped yield curve, bonds with longer maturity have a higher yield than shorter-term bonds. This difference is due to the time-related risk. A normal shape is usually an indication of economic expansion.
In an inverted-shaped yield curve, short-term yields are more than long-term yields. It can be a sign of an upcoming recession. A Duke University professor in the 1990s found the development of inverted yield curves before the last five U.S. recessions.
Flat or Humped
In a flat or humped yield curve, the short and long-term yields are close to each other. It usually serves as an indication of economic transition. When an economy moves from expansion to slower development or even recession, yields on longer-maturity bonds fall while yields on short-term securities likely go up. This results in a normal yield curve forming into a flat one.
Theories behind the Shape of the Yield Curve
There are mainly three theories that try to explain the logic behind the shape of the yield curves:
This theory says the expectations of the rising interest lead to a positive yield curve.
Liquidity Preference Hypothesis
This theory says that investors prefer higher liquidity of short-term debt. So, any deviation from a normal curve is only a temporary thing.
Segmented Market Hypothesis
This theory believes that certain investors have a liking for certain maturity segments. Such behavior makes the curve a reflection of the current investment policies.
Importance of Yield Curve
Based on the shape of the yield curve as discussed above, it helps determine the economy’s current and future position. Also, as discussed above, the Treasury yield curve serves as a benchmark for other market instruments.
Yields on the Treasury bonds are usually among the lowest as they are risk-free. This helps bond investors to compare the Treasury yield curve with other riskier assets, like corporate bonds. The yield difference between the two is called “spread.” A general rule of thumb is closer the yields, the more confident the investors are in the other bond. Also, the spread usually widens during recessions and contracts during an economic recovery.
Factors Influencing Yield Curve
Different factors impact the movement on either end of the yield curves. Short-term interest rates – or “the short end” of the yield curve – are influenced by the expectations for the U.S. Federal Reserve policy or, in general, what the government will do in the future. When the Fed is expected to raise the interest rate, the short-term rates rise, while the rates drop when a cut is expected.
Long-term bonds – or the “long end” of the curve – are also, to some extent, affected by the Fed policy expectations. Other factors, however, also play a role in the movement of the long-term yields. Such factors are the outlook for economic growth, inflation, supply-and-demand, and investors’ overall attitudes towards risk.
Usually, factors like low inflation, depressed risk appetites, and slower growth support the price performance of long-term bonds. Or, we can say cause the yields to fall. While higher inflation, elevated risk appetites, and higher inflation cause the yield to rise. Together, all these factors help to shape the direction of the long-term bonds.
How to Benefit from It?
The shape of the yield curves offers investors an insight into the short-term interest rates and economic growth. Though they are not a sure shot, they can provide guidance when properly used. Also, it must be noted that yield curves are more helpful to short-term investors. A long-term approach for a bond investor must always be based on specific objectives instead of technical indicators like the yield curve.
Short-term investors can make a profit by reading the shape of the curve and then adjusting their positions based on that. However, predicting how the yield curve may change is a very difficult task.