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Yield Curve Definition
The yield curve is a graphical representation (line plot) of the interest rates of similar quality bonds with varying maturity dates. The most commonly reported yield curves plot the 3-month, 2-year, 5-year, 10-year, and 30-year U.S. Treasury Notes.
The yield curve is compared against the interest rates paid by other debt instruments in the market. This comparison is used by economists to make economic forecasts and financial analysts to project the value of debt instruments.
A Little More on What is the Yield Curve
The value of the yield curve is of future projections on interest rates. The shape of the curve takes on three main shapes:
Normal Yield Curve – In a normal market, the yield curve will slope upward gradually with longer-term bonds having a higher interest rate that short-term bonds. This is based on the higher level of risk associated with long-term bonds, as there is no certainty in what future bonds rates will do. Also, if you believe that future long-term rates will rise, it makes investors stick with short-term bonds (remember, if rates rise then existing bonds with lower long-term rates will be worth less). This can cause a rush to short-term securities, which lowers their yield (higher demand lowers current yield, as the issuer does not have to pay as much to attract purchasers). This makes the curve slope even steeper.
Inverted Yield Curve – An inverted yield curve is the exact opposite of a normal curve. Short-term yields are higher than long-term yields. This type of curve portends a future recession. When investors believe that future bond rates will continue to drop, they rush to purchase existing long-term bonds (which will be more valuable new issuances) rather than short-term bonds. The increased demand for long-term bonds raises the purchase price, but it pushes down yields further. The lack of interest in short-term bonds pushes down the price, but it raises the yield. This further inverts the yield curve.
Flat (or Humped) Yield Curve – A flat yield curve is not really a curve. The yields on short-term and long-term bonds are very similar. This type of curve is common with economies in transition (positive to negative or vice versa). When transitioning from high to low performance, yields on long-term bonds fall and short-term bonds rise. This tends to invert the yield curve from normal to flat. When transitioning from low to high performance, there is an expectation that long-term bond yields rise and short-term rates will fall. This shifts the curve away from inverted to flatter.
References for Yield Curve
- · The tax‐adjusted yield curve, McCulloch, J. H. (1975). The Journal of Finance, 30(3), 811-830. The tax-adjusted yield curve according to this paper helps to predict and evaluate the extent to which tax levied on both good and services produced in an economy affects the yield curve.
- · The US Treasury yield curve: 1961 to the present, Gürkaynak, R. S., Sack, B., & Wright, J. H. (2007). Journal of Monetary Economics, 54(8), 2291-2304. One of the most important factors in finance is the discount function which is defined as the variable that helps to determine the value of the future nominal payment. The discount function is deduced from the Treasury yield curve. This research paper sets it example based on the estimate of the Federal Reserve Board since most researchers don’t possess the history of high-frequency yield curve estimate. According to this paper, the estimate was acquired from a daily frequency from 1961 till this moment (as at the time of this research work). After a certified method has been employed, the result can be used to fill any horizon’s rate.
- · The macroeconomy and the yield curve: a dynamic latent factor approach, Diebold, F. X., Rudebusch, G. D., & Aruoba, S. B. (2006). Journal of Econometrics, 131(1-2), 309-338. According to this paper, a model that employs the use of latent factor (such as scope, level and curvature) and also larger economic value (such as inflation, real activities, tariffs and embargo) was adopted. The aim of this research is to explain the various interactions between the yield curve of and the macro-economy of a nation/firm. The effects of the macro variable were seen as the outcome of future movement seen in the yield curve. Also, the result of the paper has also been related to upcoming changes although they are still termed as a hypothesis.
- · What does the yield curve tell us about GDP growth?. Ang, A., Piazzesi, M., & Wei, M. (2006). Journal of Econometrics, 131(1-2), 359-403. According to this research, a dynamic model for GDP growth and the yield that totally differentiates the expectation of GDP was constructed and used as the building block of the whole research. According to these analyses, this model does not permit arbitrage which is totally different from other research. According to this paper, it was hypothesized that the short rate has a more predictive influence on any term spread. Although, previous studies states that the term spread predicts GDP but these returns are unrestricted and do not depicts “regressor endogeneity.” This model suggests the use of lagged GDP as the most suitable method to measure slope.
- · Some lessons from the yield curve, Campbell, J. Y. (1995). Journal of economic perspectives, 9(3), 129-152. This research paper particularly explains the interaction between the long-term and short-term interest rate as well as the various evidence surrounding the term structure. Note that when long rate increases compared to short rate, the short rate tends to rise which is in veiled with the expectation hypothesis and the long rate begins to decline which is the opposite of what the expectation hypothesis says. According to the 1994 monetary policy in the United States, this research also explains the reaction of the United State bond market as well as the reviews on the maturity structure of her government debt.
- · Decomposing the yield curve, Cochrane, J. H., & Piazzesi, M. (2009). Decomposing the yield curve. In the course of this research, an affine model was constructed which helped the bond risk premia. With the understanding of the risk premia, this research was able to explain the real expectation via information gotten from the risk-neutral dynamics. According to this paper, the term structure of the risk premia which is a forward rate which calculates the expected excess future return as well as the curvature factor and the current slope.
- · The yield curve as a predictor of US recessions, Estrella, A., & Mishkin, F. (1996). The yield curve as a predictor of US recessions. The yield curve according to this paper is the spread that encompasses the interest rates. Take, for example, the interest rate on ten years Treasury note and three months Treasury bill. According to the predictor of the US recessions, the yield curve is known as a valuable forecasting tool that has helped to calculate and evaluate the US recession departments many a time. The yield curve is a simple forecasting tool which beats other macroeconomic and financial indicators in predicting recession that is yet to come.
- · Volatility and the yield curve, Litterman, R., Scheinkman, J., & Weiss, L. (1991). Volatility and the yield curve. Journal of Fixed Income, 1(1), 49-53. The term volatility according to this research work is defined as the level of uncertainty in the future price of an economic commodity and financial product. Since the yield curve is an effective forecasting tool, this paper explains the relationship between these two variables.
- · The slope of the credit yield curve for speculative‐grade issuers, Helwege, J., & Turner, C. M. (1999). The slope of the credit yield curve for speculative‐grade issuers. The Journal of Finance, 54(5), 1869-1884. Although, a lot of economists believes that the credit yield curve used by risk bond issuers exhibits a downward slope and this is in sync with the research analyses of (Sarig and Warga (1989), Fons (1994)). According to this paper, a set of the bond was issued by a firm with similar beliefs in the liability structure but with different maturities and assume that the credit quality is constant. The result was the direct opposite of other research work when the bonds were computed; the slope was negative which shows that the maturity has a sample bias problem.
- · Predicting real growth using the yield curve, Haubrich, J. G., & Dombrosky, A. M. (1996). Predicting real growth using the yield curve. Economic Review, 32(1), 26-35. The growth rate according to this paper can be predicted with the help of the yield curve. This process is one of the most important and effective method employed in evaluating the rate at which an economy blooms in the long-run.
- · Why does the yield curve predict output and inflation?, Estrella, A. (2005). Why does the yield curve predict output and inflation?. The Economic Journal, 115(505), 722-744. The main reason as regards the relationship and why the slope of the yield curve is termed as a significant predictor of real economic activities and inflation (empirical results) is yet to be ascertained. This paper assumed an analytical rational expectation model to analyses the relationship between this two factors (empirical results) and according to this model, it indicates that the relationships between the empirical result are majorly influenced by the monetary policy regime. Although, the yield curve should have predicted the outcome of this situation since it has the most substantial predictive power and an invaluable forecasting tool.
- · Economic determinants of the nominal Treasury yield curve, Evans, C. L., & Marshall, D. A. (2007). Economic determinants of the nominal Treasury yield curve. Journal of Monetary Economics, 54(7), 1986-2003. In the course of this research paper, an approach which helps to determine macroeconomics shocks which manipulate model-based empirical shock measures was developed. The main reason for this is because the macroeconomics shocks account for a large percentage of the variability in the nominal Treasury bill which includes the shifting of the yield curve to a parallel level. The reaction of the monetary policy is a very important pathway for the movement of the real rate and expected inflation rates. According to this research, it was observed that the fiscal policy shock is an important source of interest rate inconsistency.