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Understanding the Yield Curve: Definition and Analysis

The yield curve is one of the most important concepts used by economists and fixed income analysts when it comes to analyzing bonds, getting a good grasp of conditions in the financial markets, and weeing out trading possibilities. It is basically the relationship expressed on a graph between the interest rates and the time to maturity of a given debt. Mathematically speaking, the yield curve is a function that is in terms of the time to maturity and it has to be for bonds with equivalent credit quality and expressed in a given currency.

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The shape of the yield curve is considerably important for getting an idea about the trend of interest rate changes in the future and economic activity to come. The curve is usually asymptotically upward sloping with time. A popular explanation for this is that with time, investors find greater risk in putting their money in bonds and hence require an increased risk premium for investing. Hence, yield curve goes up with time. Another one is that the market is speculating risk rates rate to increase, because of which if investors delay investment, they may get greater returns. Therefore those investors who choose to invest at this time need to get compensation for the future rise in the risk-free rate, leading to a rise in the rate on long-term securities. The curve can otherwise be flat, steep, or inverted.

The shape of the yield curve could be described as relatively steep following 2002. It however began to flatten out over the years coming to 2004. It continued to flatten over the following time with the Fed short-term term rates but keeping long term interest rates low. Consequently, the yield curve remained inverted as well following the Fed’s policy. After that efforts were made to make the curve steep which did not prove very successful immediately but started to give results later on.

The market and the Fed have had different outlooks regarding policy that should have been adopted since 2002. The Fed funds rate remained negative in mid of year, below the CPI index. Market analysts argued that such a policy is consistent with recessionary conditions but not with healthy economic growth which leads to a rise in interest rates, requiring the Fed to take up its fund rate target which it shunned to do at that time. Its aim appeared to be to create a little inflation to aid the stock market and then control it after the desired effect was achieved. Analysts argued that this was not considering the potential ill effects of this move on the market which would have to be dealt with.

In the following years, however, the Fed’s outlook began to improve in the minds of the analysts. There was the conviction that interest rates are unlikely to be raised in the months in 2004 which prompted investors to buy long long-terms. This led to the flattening of the yield curve. However, the outlook began to deteriorate in the later years. The Fed boosted the federal funds rate to around 3.5 percent, as an attempt to keep inflation low. This was followed by speculation that the rate will continue hiking at an increasing rate which got analysts worried about whether the economy was strong enough to handle it and brought fears of prompting a financial crisis, not unlike that in the 1980s. Thus the general view from the news appeared to be that whether the curve got flat or inverted, it hinted towards a weaker federal reserve rather than a downturn of the economy.

With the inception of the new chairman Bernanke in 2006, it was hinted that the central bank may have to keep on raising interest rates to control inflation in the midst of expected and healthy economic expansion. He also had to address the growing concern that with interest rates on two-year treasury notes rising higher than ten-year notes, leading to inversion of the yield curve was not a signal of a downturn. Following the beginning of a slowdown in growth in 2007, the Fed kept up with the policy for controlling inflation which kept the yield curve flat, amid expectations of low volatility in economic conditions. Then the recession following the financial crisis began which prompted the Fed to help out the tanking banks. The gap between short-term and long term debt interest rates started to widen, leading to a steeper curve after a long time. This was a sign of economic recovery, contrary to the previous trends in the curve which was taken to be a good sign. This was because of aggressive rate-cutting by the Fed to help the banks borrow and encourage investors as well. However, it led to inflationary pressures which were considered necessary in order to avoid a deeper financial crisis.

Looking at the trend that the yield curve has taken following 2002, one gets the idea that the press explanation via market analysts faired better in terms of explaining the yield curve than the Fed’s reports. The biggest evidence of this was during the mid-years following 2003 when the curve got flattered and inverted in the long-term debt section which was continuously expressed as a sign of impending recession. The Fed chairman went to great lengths to show the contrary by pointing out the economic expansion during the years and the strength of the retail sector. However, the economy did eventually experience a recession, and only after the Fed initiated aggressive rate-cutting did the curve become steep with the longer-term debt having higher interest rates. This was a sign of recovery and more in tune with the economic conditions that prevailed.

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