Yield Curves and the Economy
The relationship between bond market interest rates and the remaining time to maturity of debt securities is often expressed in a chart form known as a yield curve. A yield curve is a graph constructed by plotting the current interest rates for bonds of various bond maturities, with interest rates represented on the Y-axis and time to maturity represented on the X-axis.
A yield curve can be constructed for any kind of debt. There is a yield curve for U.S. Treasury Bonds, Bank of Canada Bonds, one for bonds with a AAA credit rating, and a curve for each bond credit rating category.
The lower the bond’s credit rating the more the yield curve will be influenced (or contaminated) by credit default issues. Investors that monitor yield curves generally prefer to use yield curves built upon government bonds, thereby eliminating the influence of credit default.
Yield curves exist for the bonds of each sovereign issuer.
Investors that monitor yield curves believe that the shape of a yield curve holds predictive abilities for the underlying economy. They believe that bond investors, when buying and selling, include their expectations of inflation, real interest rates and their assessments of risks, current and future, in their pricing decisions. This assumption then extends into the construction and shape of the yield curve. As a result, by monitoring the yield curve’s current and evolving shape, investors can assess economic expectations and, thus, the future economic outcome.
When looking at yield curves, an investor should understand that, historically, the interest rate policies of governments and their central banks influence the bond market interest rates for the short-term bonds, but the market’s inflation expectations rule the interest rates of longer-term bonds.
If an investor wishes to utilize yield curves as an economic indicator, they should follow the yield curves for a specific country, or sovereign issuer, and view the yield curve as an economic comment upon that specific country. By doing so, the investor minimizes the corrupting influences of credit and currency risks/fluctuations.
The three basic yield curve shapes and their interpretations
There are three basic yield curve types as outlined below and discussed in the following sections:
Yield curve summary
Yield curves, like any single forecasting tool, are not perfect and should be used by investors in conjunction with other investment analysis tools. Historically, yield curves have a relatively long lead time in their forecasting ability. Typically, changes in a yield curve’s shape may be forecasting an economic change anywhere from 6 to 12 months into the future. This makes it very difficult for individual investors to utilize yield curve analysis with an investment approach that relies upon a trading strategy.
In addition, the yield curve’s shape is very sensitive to interest rate changes. It is often said that the yield curve has predicted 10 of the last 7 recessions. This does not mean yield curves have no value, but rather yield curves are useful in investment analysis when accompanied with other investment assessment tools.
In addition to the shape of the yield curve and the steepness of the curve, investors should also observe the actual level of interest rates.