The Yield Curve

The bond market can be used as a predictor of inflation and the direction of the economy, both of which directly affect the prices of everything from stocks and real estate to household appliances and food.

In this Wiki, we will take a look at the common types of yield curves and some explanations for why they exist.

The Yield Curve

All bonds have various maturity dates. For example, the United States may have issued 3 month, 9 month, 2 year, 5 year, and 10 year bonds. Bonds with a longer remaining lifetime tend to yield more than those with a shorter lifetime under normal market conditions. This is what we refer to as a normal yield curve. A flat yield curve is where all the remaining lifetimes have the same rate of interest. An inverted yield curve is where longer dated bonds yield a lesser rate of interest compared to shorter-term bonds.

The yield curve is a picture of where interest rates are today. It’s also a picture of where the market expectations are for where interest rates will be in the future. The yield curve shows the rate of return that can be locked in now for various terms into the future.

The investments that are constructed in a yield curve should all have the same risk, the same features, and the same coupon rate. This means that if you are looking at a yield curve for US treasuries then it will only contain information about US Treasuries and not some other instrument.

As another example, to construct a yield curve of German government bonds of varying coupon rates the variants in those coupon prices and rates can be factored out so that price is comparable. The idea is that you want to compare apples to apples and not apples to oranges when constructing a yield curve.

There are four basic shapes of yield curves that you should be aware of:

1. The Normal Yield Curve
2. The Inverted Yield Curve
3. The Flat Yield Curve
4. The Hooked Yield Curve

The Normal Yield Curve

The normal yield curve is characterized by the nearby yields being lower than further dated yields. This progresses from the shortest dated and lowest yield to the longest dated and highest yield in a relatively smooth curve just like the chart below.

An image of the normal yield curve.

Inverted Yield Curve

The inverted yield curve is where the shorter dated investments are yielding more than longer dated yields. This situation tends to happen very rarely. But times that this situation does happen are when the markets are extremely uncertain which causes a flight to safety. When the market gets scared it will dump its money into "risk free" assets causing prices to inflate on shorter lifetime to maturity investments.

This typically occurs for a short period of time before reverting back to a more normal yield curve.

An image of an inverted yield curve.

Flat Yield Curve

A flat yield curve indicates that yields for short, medium and long term investments are all roughly the same. This tends to happen when the market is really uncertain of what the future holds. The future direction of the economy could be better or worse than it is right now but the market is in a wait-and-see mode for more information to help understand what the next move will be.

An image of the flat yield curve.

Hooked Yield Curve

The hooked yield curve is also sometimes called a humped yield curve. It resembles a bell curve with a long tail. What this situation indicates is that medium-term rates exceed both the short term and the long term rates.

When we are talking about government debt this is typically interpreted as a slowing of the economy as a whole.

An image of the humped yield curve.

The 3 Explanations for Yield Curves

1. The Liquidity Preferences Hypothesis

Investors dislike having their money tied up for too long and will demand extra returns for having to put their money at risk for longer holding periods. The longer the investor has to defer their current consumption the more marginal compensation they will demand in order to pay for not being able to use their hard earned money today.

Investors will almost always prefer a high liquidity investment and will accept a lower return to get the safety of knowing they can get out of their investment at any time should they need to. This ensures that when investors want to sell their holdings they can do so very efficiently without any headaches.

2. The Expectations Hypothesis

The yield curve is a picture of what people expect interest rates to be from now and into the future. For example, a humped yield curve with a peak at two years out means that people generally expect interest rates to rise for two years, after which they will then trend down again.

In the Forex market traders spend their lives trying to predict and move prices in line with what their expectations are for central bank interest rate changes. When we are talking about futures, if a central bank changes to its benchmark interest rate it will have massive implications on the government debt market.

Trading in Forex is highly influenced by interest rates and the market expectations for where those interest rates are going in the future.

3. Market Segment Hypothesis

This is based on the idea that there is not one continuous debt market. Rather, there are several distinct segments with different players within each segment.

For example, the short term market is dominated by banks and money market dealers who through very competitive supply and demand arrive at a series of short term interest rates. The second market segment which includes mutual funds, corporations and casualty insurers typically only borrow and invest in the medium-term because this is what their businesses rely on. The long term debt markets are mostly influenced by businesses with long term projects and liabilities such as pension funds, life insurers and property companies that buy and sell from each other which in doing so sets the rates in the long end of the market.

Basically, what the market segment hypothesis is saying is that certain segments of the market have different needs and will borrow debt or seek interest rates for various reasons, not just to make a profit.

In the real world, the answer to how interest rates and yield curves are derived is likely a combination of all these hypotheses. There are definitely real reasons for all of these hypotheses to have some real-world effects on prices.