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What Is The Yield Curve?

What Is The Yield Curve?

It's no secret that the bond market is the largest in the world. The well-oiled market machine burns fuel as debt. But when you look inside, it's interspersed with performance ratings, which tie the engine to the battery, the central bank.

Yield curves are a mere graphical representation of this relationship. They are praised for their simplicity, but above all for their predictive qualities.


What is a yield curve?

In technological terms, a yield curve is a graphical representation of the variation in bond rates. Take bonds with the same credit quality but different maturity dates and plot that difference.

Concretely, a yield curve is a way of measuring the prospects of bond investors.

Regarding the yield curves, there are three main factors:

  • Economic growth: makes the curve steeper and increases yields. This is because the competition for capital is higher. Unrestricted economic growth is also exposed to the risk of rising inflation due to rising aggregate demand.

  • Inflation: rising inflation leads to larger interest rates and lower purchasing power. Inflation reduces demand for bonds, as fixed-income securities are probably the worst investment in an inflationary environment. So, it increases the yields.

  • Interest rates: Central banks control interest rates and react by raising or lowering them, depending on market conditions. Rising interest rates lead to higher short-term returns.


There are five types of yield curves, each indicating different market conditions:

  • Flat: A flat yield curve is characteristic of a transition period, between normal and inverted or vice versa. A flat curve means that there is the same return between short-term and long-term bonds.

  • Humped: A humped yield curve is rare and often predicts an economic recession. This indicates that medium-term returns are greater than both short-term and long-term returns. Metaphorically speaking, it's like a hit in the road - it's not there yet, but it's fast approaching.

  • Inverted: When long-term performance falls below short-term performance, the curve reverses. It occurs when the perception of short-term risk is higher than that of long-term risk. The inverted yield curve is an important indicator with a history of falling market forecasts.

  • Normal: This is the most common curve and is therefore considered a "normal" curve. In a good way, long-term creditors consider this to be riskier (the chances of adverse events increase over time). Hence, they demand higher pay in terms of higher interest rates. However, this rate does not increase exponentially, but gradual and diminishing returns do-follow.

  • Steep: The steep curve shows a much faster increase in long-term returns. It looks like a normal curve, except the difference between short-term and long-term returns is bigger. They usually take place at the start of an expansionary economic period.


What does the yield curve mean?

As the United States has the most important debt market in the world (US Treasury), the yield curve between short-term (3-month) and long-term (10-year) bonds has been an important indicator of market downtime.

Of course, the rates on long-term bonds are higher than short-term bonds because short-term debt is less risky. Therefore, when short-term bond rates fall, and long-term bond rates rise, investors avoid short-term market prosperity.

Historically, inverted yield curves have preceded every recession since 1956. The first reversal in recent years was in March 2019 and was quickly followed by a market downturn.

There are three theories of the yield curve:

  • Expectation Theory: A theory according to which forward rates only represent expected future rates. The flaw of this theory is that it does not include interest rate risks.

  • Market Segmentation Theory: A theory that asserts that short and long-term interest rates are not correlated because they have different investors. Because each segment is a category on its own, the returns of one class do not have to predict the returns.

  • Preferred Habitat Theory: The hypothesis that some bond investors prefer bonds of a certain maturity to others. Therefore, they are only willing to buy bonds outside their preferred range if a substantial risk premium is. This theory differs from market segmentation theory in that it emphasizes short-term profitability, which means that investors model their risk based on time rather than performance.


What does the yield curve look like?

A yield curve can inform the general sentiment of the debt market, the largest market in the world.

When the yield curve reverses, you should look for lower risk and possibly buy recession protection.

Professional investors study at the yield curve for four important reasons:

  • Interest Rate Forecasts: Central bank interest rates are the main driver of monetary policy. A steep curve may indicate an increase in the interest rate, while an inverted curve may indicate a decrease in the interest rate.

  • Maturity and Yield Compensation: the slope of the curve determines the trade-off between maturity (represented by x) and yield (represented by y).

  • Profitability of the Financial Sector: Financial institutions, such as banks, provide short and long-term loans. Therefore, their profits depend on the difference between these rates. A sharp curve is positive, while an inverted curve is negative for the financial sector.

  • Relative Stock Price: The curve can indicate whether a particular stock is undervalued or overvalued. When comparing the efficiency with the curve, if the rate of return is lower than the curve, the safety is overestimated.


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