In the financial news we often read about the Yield Curve. What exactly is it?
A Yield Curve is a plot of the yields for different maturities of debt. This can be for any debt, but the most common used when discussing yield curves is the debt of the Federal Government. The yield curve is observed by its slope.
A curve with a positive slope (up and to the right) or a steepening curve, i.e. one that's becoming more positively sloped or less negatively sloped, may indicate several different situations. The Kansas City Federal Reserve has a nice paper that summarizes various economic theories about the yield curve, and even though it's a bit dated, the theories are still valid. I'll summarize the major points here.
A positively sloped yield curve can indicate expectations of inflation in the future. The longer a security has before it matures, the more opportunities it has to be affected by changes in inflation, so if investors expect inflation to occur in the future, they may demand higher yields on longer-term securities to compensate them for the additional inflationary risk. A steepening yield curve may indicate that investors are increasing their expectations of future inflation.
A positively sloped yield curve may also reflect expectations of deprecation in the dollar. The publication linked before states that
depreciation of the dollar may have increased the perceived risk of future exchange rate changes and discouraged purchases of long-term Treasury securities by Japanese and other foreign investors, forcing the yields on these securities higher.
Supply shocks, e.g. decreases in oil prices that lead to decreased production, may cause the yield curve to steepen because they affect short-term inflation expectations significantly more than long-term inflation. For example, a decrease in oil prices may decrease short-term inflation expectations, so short-term nominal interest rates decline. Investors usually assume that long-term inflation is governed more by fundamental macroeconomic factors than short-term factors like commodity price swings, so this price shock may lead short-term yields to decrease but leave long-term relatively unaffected, thus steepening the yield curve.
Even if inflation expectations remain unchanged, the yield curve can still change. The supply of and demand for money affects the "required real rate," i.e. the price of credit, loans, etc. The supply comes from private savings, money coming from abroad, and growth in the money supply, while demand comes from private investors and the government. The paper summarizes the effects on real rates by saying
Lower private saving, declines in the real money supply, and reduced capital inflows decrease the supply of funds and raise the required real rate. A larger government deficit and stronger private investment raise the required real rate by increasing the demand for funds.
The upward pressure on future real interest rates contributes to the yield curve's positive slope, and a steepening yield curve could indicate an increasing government deficit, declines in private savings, or reduced capital coming in from abroad (for example, because of a recession in Europe that reduces their demand for US imports).
- Monetary policy may also affect the yield curve. For example
an easing of monetary policy when is economy is already producing near its capacity ... would initially expand the real money supply, lowering required short-term real interest rates. With long-term real interest rates unchanged, the yield curve would steepen. Lower interest rates in turn would stimulate domestic spending, putting upward pressure on prices.
This upward price pressure would probably increase expected inflation, and as the first bullet point describes, this can cause long-term nominal interest rates to rise. The combination of the decline in short-term rates and the rise in long-term rates steepens the yield curve.
Similarly, an inverted yield curve or a positively sloped yield curve that is becoming less steep may indicate the reverse of some or all of the above situations. For example, a rise in oil prices may increase expectations of short-term inflation, so investors demand higher interest rates on short-term debt. Because long-term inflation expectations are governed more by fundamental macroeconomic factors than short-term swings in commodity prices, long-term expectations may not rise nearly as much as short term expectations, which leads to a yield curve that is becoming less steep or even negatively sloped.
Forecasting based on the curve slope is not an exact science, just one of many indicators used.
Note - Yield Curve was not yet defined here and was key to my answer for What is the "Bernanke Twist" and "Operation Twist"? What exactly does it do? So I took the liberty of ask/answer.
Yield is the term used to describe how much income the bond will generate if the bond was purchased at a particular moment in time.
If I pay $100 for a one year, $100 par value bond that pays 5% interest then the bond yields 5% since I will receive $5 from a $100 investment if I held the bond to maturity.
If I pay $90 for the same one year bond then the bond yields 17% since I will receive $15 from a $90 investment if I held the bond to maturity.
There are many factors that affect what yield creditors will accept:
- Ability of borrow to repay.
- Uncertainty of the future.
- Inflation expectations.
- The desire to have money today versus in the future.
It is the last bullet that ultimately determines yield. The other factors feed into the creditor’s desire to hold money today versus receiving money in the future. I desire money in my hand more than a promise to receive money in the future. In order to entice me to lend my money someone must offer me an incentive. Thus, they must offer me more money in the future in order for me to part with money I have.
A yield curve is a snapshot of the yields for different loan durations. The x-axis is the amount of time left on the bond while the y-axis is the yield. The most cited yield curve is the US treasury curve which displays the yields for loans to the US government. The yield curve changes while bonds are being traded thus it is always a snapshot of a particular moment in time.
Short term loans typically have less yield than longer term loans since there is less uncertainty about the near future.
Yield curves will flatten or slightly invert when creditors desire to keep their money instead of loaning it out. This can occur because of a sudden disruption in the market that causes uncertainty about the future which leads to an increase in the demand for cash on hand.
The US government yield curve should be looked at with some reservation however since there is a very large creditor to the US government that has the ability to loan the government an unlimited amount of funds.