I refer to the term structure of interest rates: yield curve. If you still don't have a clear idea of what it is, then this post is for you.
What is the term structure of rates
In a simplified way, let's consider bonds of the same investment category (Eg US government bonds) but with different deadline (from 3 months to 30 years). If we combine the points identified by the total return the investor receives if he holds the bond to maturity and the time remaining before maturity (the residual life) we get the yield curves o term structure of interest rates.
This curve represents the existing relationship on a certain day, according to the market, between the rate of return offered by a US government bond at a given maturity and the maturity itself.
The graph below shows the yield curve for the US in 1989, in 2000 and in 2014.
The first value, the first point of the line, is the spot interest rate, i.e. the rate for the shortest maturity to 3 months, influenced more directly by the US central bank.
Two important aspects when looking at the yield curve are the level of the curve and the crafts.
The level of the interest rate curve
Il level of the curve and its displacements can reflect the monetary policy behavior of the central bank. Think of the maneuvers of quantitative easing and generally expansionary monetary policy by the Fed since the outbreak of the Great Recession in 2008. These moves have contributed to shift the yield curve downwardsby reducing interest rates on various maturities.
The slope of the yield curve
THEinclination of the yield curve is influenced by various factors: expectations, risk premia and market segmentation/preferences. There are two main explanations for its trend: i risk premiums, that investors require to invest in long-term versus short-term bonds and the expectations of investors on interest rates in the future. These expectations in turn reflect what the market expects about:
- price trend;
- the performance of the economy;
- behavior of the central bank.
In short, the inclination of the curve is not easy to interpret.
The three types of yield curve
As can be seen from the three cases in the graph, the yield curve can take three typical forms, which we will now analyze.
Flat
I short-term rates are about equal to long-term rates (Red line). This form can signal an expectation of slowdown in economic activity. Such a curve is unusual and usually indicates a transition to a positive or negative slope.
In the graph, the "red" curve indicated a slowdown in economic activity in the USA and, effectively, there was then a recession in the years 1990-1991, due to a consumption collapse.
Negative slope
In this situation, as maturities increase, rates decrease (blue line). Financial markets expect short-term rates to be lower in the future. That form is indicative of a recessionary and/or deflationary economic phase and may reflect expansionary monetary policy expectations.
Generally this type of inclination does not last long. In early 2000 the yield curve was downward sloping. About a year later the American economy entered a recession, decreeing the end of the period that Alan Greenspan had defined as one of "irrational euphoria".
Positively inclined
is thenormal slope of the curve therefore, as maturities increase, rates increase (green line). This happens because long-term bonds are riskier: it is easy to understand that if an investor deprives himself of a sum today, lends it and knows that he will be able to receive it back in many years, he will ask for a biggest prize.
The slope of the curve can also be explained by expectations: financial markets expect higher short-term interest rates in the future. That inclination is indicative of an expansionary and/or inflationary economic phase and may reflect expectations of a restrictive monetary policy (increase in interest rates).
This is precisely the situation today with reference to the US economy: expectations of a recovery in production and a return of interest rates to normal levels (compare with the opinion expressed in our asset allocation).
Inside the our site, in Financial globe, you can see gods yields offered by bonds which have a maturity of 10 years divided by country.
