The yield curve is an oft-cited and widely used tool in fixed income investing. For credit unions - indeed all financial institutions - understanding and using this tool effectively is a key element to business success. This article will provide a quick primer on the drivers of the yield curve to assist in future business decisions and actions.
What is the yield curve?
Simply put, it is a line graph that shows the relationship between bond yields and bond maturities for bonds that have the same class and quality. Typically, the yield curve starts at the shortest maturity and extends out in time, depicting yield differences (or yield spreads) along the maturity spectrum. These differentials are also referred to as "the slope" of the yield curve and they convey what the relationship in the marketplace is between interest rates and maturities.
A yield curve can be created for any class of fixed income securities, but generally, the most frequently quoted curve is the yield curve. The yield curve shows the relationship of Government of Canada bond yields to their maturity, since it is without credit risk and includes securities of virtually every end-date. A "normal" yield curve is upward sloping; long-term interest rates are higher than short-term interest rates along the maturity spectrum.
Why is a "normal" yield curve upward sloping and what determines the shape of a yield curve at any given point in time?
Generally speaking, there are two main drivers of the shape of the yield curve: investor expectations regarding future interest rates and "risk premiums" associated with holding longer (as opposed to shorter) maturity bonds. There are three theories that attempt to explain these two drivers in more detail.
Pure Expectations Theory: The slope of the yield curve is affected only by investors' expectations. If rates are expected to go higher in the future, then the curve will slope upward. Conversely, if interest rates are expected to go down, the curve will slope downward.
The Liquidity Preference Theory: This theory builds on the Pure Expectations Theory by stating that not only do long-term interest rates reflect investors' expectation of future interest rates, they also reflect a liquidity premium (or term premium). This premium must compensate investors in long-term interest rates for the added uncertainty of having their money "tied up", including the price uncertainty associated with such an alternative. All else being equal, this liquidity preference makes longer term interest rates higher than they would be otherwise, in order to compensate for this risk.
The Preferred Habitat Theory: A further expansion on the above two theories states that investors have distinct preferences in terms of time horizons, and they will not stray from these preferences unless induced to do so by higher rates. Since most fixed income participants are short-term investors, long-term interest rates must be higher to induce them to move to the long end of the curve.
The interplay of these theories shows the challenge in analyzing and interpreting the yield curve and the signals it can send us.
When does the "slope" of the yield curve change?
Remember, the slope is the differential between short-term and long-term interest rates. If we assume that the three aforementioned theories support an upward sloping curve, then any departure from this upward slope signals a shift in investor expectations in relation to interest rates. It is important to stress that the yield curve slope reflects what the market expects to happen, not what is currently happening. If the slope becomes steep, it is an indication that interest rates will need to rise in the future due to continued economic growth, and that future inflation must be compensated by higher interest rates.
Conversely, if the slope of the curve gets flat, it is an indication of moderate economic growth and inflation in the future and thus investors will not demand a risk premium to hold long-term bonds. If the slope of the curve becomes negative (or inverted) then long-term interest rates become lower than short-term interest rates. Investors then believe that a recession is imminent and that interest rates will decline in the future. In this case, risk premiums associated with long-term interest rates are outweighed by the desire to lock in long-term rates before they decline.
Over time, all the changes in the yield curve can happen at various speeds and degrees and have proven to have an excellent track record as predictors of future economic conditions. Understanding how the yield curve works and what it is telling us is critical for credit unions as a tool to gauge economic growth and assess their businesses in the context of future interest rate movements.
Filip Jakobs is Central's portfolio manager.
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