La yield curve (yield curve in English) is a graphical representation that illustrates in real time the return that can be received on various types of bonds, held until their maturity. For this reason it is also called term structure of interest rates. The bonds considered in constructing the curve can be those issued by banks, companies or sovereign states. Since government bonds are considered safer by financial investors (in some cases they are even risk-free), the yield curves used in the analysis of financial markets usually refer to government bonds, for the purpose of comparing curves of different countries at the same time or curves of the same country at different times. The shortest maturity generally considered when drawing the curve is 3 months, while the longest refers to securities with a maturity of 30 years. In the case of yield curves referring to bank bonds, the shorter maturities can even start from overnight rates, and also consider rates with intra-annual maturities even after the first year (e.g. 18-month yields).
Yield curves are a useful tool for understanding the opinion of financial investors in the various time horizons considered by the curves. In particular, i two most important elements of their configuration are made up of level and from slope of the curve. level it is generally linked to short-term yields, which, in turn, are influenced by the reference rates determined by central banks. In fact, as is well known, monetary policy can only act on short-term rates, while long-term rates are influenced above all by expectations on the short-term interest rates that will prevail in the future. In the case of the ECB, for example, there is a "corridor" of official rates which has as a lower threshold the interest rate that banks can earn on excess reserves held at the central bank, and as an upper ceiling the interest rate on refinancing marginal, i.e. on the loans that banks can request from the ECB beyond ordinary financing. The short-term rate in the euro area must necessarily be placed within this corridor. Obviously if the ECB reference rate is changed, the curve translates in the Cartesian plane (it moves upwards or downwards, depending on whether the change is upwards or downwards), with a slope that can remain unchanged in the various deadlines, but which usually becomes smaller for the deadlines longer. As pointed out by Andrew Goodhart and Charles Crockett, in fact, “the effect of a change in the money supply is like that of a ripple passing across the surface of financial assets, decreasing in magnitude and predictability as it proceeds further and further away.” from the initial disturbance."
Normal, flat, inverted, hump-shaped, u-shaped curve
As for the shape of the curve, the economic literature normally distinguishes four standard configurations: normal, when the curve is upward sloping, so longer-term yields are higher than short-term ones; reversed, when the curve is downward sloping, so short-term returns are greater than long-term ones; flat, when returns are similar across all maturities; a hump or inverted U (hump-shaped curve) when medium-term yields are higher than both short-term and long-term yields. It should also be noted that more recently another type of shape has been observed, completely symmetrical compared to the previous one, i.e. U-shaped, with initially decreasing returns in the short-term range and then increasing in the long-term one.
To understand the reasons for the possible shapes of the curve, it is worth observing that the structure of returns is influenced by two financial strategies by investors, which we could alternatively define as character-driven static o dynamic. In the first case, James Tobin's theory of portfolio choices shows how all bonds are imperfect substitutes for money, but with a different degree of liquidity and risk. Short-term assets (for example 3-month ones) are quite liquid, given their imminent maturity, and can be easily transformed into money in case of sudden needs without significant capital losses (for this reason they are often also called quasi- currency). Long-term assets, on the other hand, are poorly liquid (in the sense that they lack certainty about the price at which they can be exchanged) and also risky because their value can change during their life cycle, as market interest rates change, and the size of the change is closely linked to the residual life of the security (actually to its duration, which depends on the value of the coupons as well as the distance of maturity in time). For this reason, long-term assets must normally offer savers a higher return than short-term ones, precisely to compensate for their lower liquidity and greater risk. In the case of government bonds from some countries, the risk of capital losses is added to the risk of a possible default of the sovereign state.
In a dynamic strategy, however, investors' portfolio choices depend on theirs interest rate expectations that will prevail in the future. This is clear if we consider that in a given time horizon an investor can choose between purchasing a long-term security, at a return that depends on the market value of the security, or purchasing a short-term security, with a certain return, and renewing that chosen at the maturity of the security, thus always remaining short and receiving at each renewal a rate of return equal to the expected short-term interest rate. All other things being equal, and neglecting the premiums that compensate for different liquidity and risk, the two strategies must provide the same return, so the long-term interest rate can be seen as the average of the current short rate and of all short-term rates expected in the future over the life of a security. The yield curve therefore also allows us to calculate i implicit future (or forward) short interest rates, and therefore to provide indications on the expectations of market operators on the future direction of monetary policy.
Predicting recessions with the yield curve
We can then say that when the yield curve has a normal shape, with a positive slope, this implies that operators expect a favorable economic context, with stable growth prospects and inflation under control, so in the future interest rates established by central banks could remain constant or increase; the latter possibility becomes particularly likely if the slope of the curve were particularly steep, with a higher difference between long-term rates and short-term rates than would be justified by the premiums for lower liquidity and greater risk, and which reflects the expectations of future increases in central bank reference rates to counter the risk of inflation associated with an intense/long economic recovery.
The inverted yield curve obviously has opposite characteristics. Since long-term rates are lower than short-term ones, despite the aforementioned liquidity and risk premiums, this means that financial operators expect that in the future short-term interest rates will be reduced compared to current ones, probably because Economic policy authorities will lower key rates in order to combat a slowdown in economic activity or even a recession. Or, as in present times, for the reduction of inflation. For this reason, in financial literature and practice, one yield curve inverted is considered a leading indicator of a recession. In particular, following the indications of Campbell Harvey's doctoral thesis, the difference between the 10-year interest rate and the 3-month interest rate, i.e. the spread T10Y-3M, when it becomes negative, is considered by scholars to be a reliable indicator of a future recession, having predicted exactly 8 out of 8 in recent times. This spread is currently used by the Federal Reserve Bank of New York and the Conference Board in constructing leading economic indicators. Market operators, to read expectations on the future trend of the economy, use a different spread, i.e. the one between the 10-year interest rate and the 2-year interest rate (T10Y-2Y spreads). Even in this case, the existence of a negative spread, due to the inversion of the yield curve, is interpreted as a reliable indicator of future recession.
Recently, however, the American Central Bank itself has questioned the reliability of this indicator, believing that the good correlation with recessions found in the past is probably spurious. That is, both the yield curve and the performance of the economy influence each other. The Fed's thesis is based on the consideration that ten years is too long a period to be able to predict the duration and intensity of an economic cycle and the resulting monetary policy decisions between now and then. It instead favors the use of a spread on securities with a maturity of less than two years (in particular the spread between the rate on Treasury securities with a three-month maturity expected in 18 months and that on the same securities existing today); this spread would also be useful not only as a leading indicator of recessions, but also of periods of GDP growth, given that it more clearly reflects the expectations of market operators on the behavior of the Fed in the near future, something that the other spread does not is capable of doing. Perhaps it is however useful to remember that the returns on securities and therefore the yield curve are not objective data, produced by a person who observes the world from the outside and formulates forecasts, but are the result of information, interpretations and expectations, which market operators are based on this information and interpretations. Who continually review them. Let's think about the fact, for example, that at the beginning of the summer of 2022, expectations were for a recession in the USA in the first half of 2023 and a consequent rate cut by the Fed. Neither of the two events occurred.
A curve for every situation
To conclude the analysis of the possible shapes of the yield curve, it can be observed that one flat curvedenotes an economic situation that is difficult to interpret; since risk premiums and liquidity in a normal situation imply a curve with an increasing trend, the fact that it is flat could indicate operators' expectations of a decrease in interest rates; alternatively it could be the effect of some types of unconventional monetary policy, such as Quantitative Easing, in which the purchase of predominantly long-term securities led to the lowering of the final part of the curve. A hump curve it represents a rather rare event and is an indicator of a period of volatility and uncertainty on the part of operators, or it may reflect a transition phase from a normal curve to an inverted one or vice versa. More recently, as we will see shortly, the yield curve has changed a U-shaped trend, with short-term rates higher than medium-term ones, which in turn are lower than long-term ones. This trend could be explained on the basis of the observations made by the Fed economists previously illustrated: the initial part of the curve is downward because it is expected that the Central Bank will begin a downward movement in policy rates; in the final part of the curve, however, the slope returns to being positive because in the long term, once the economic slowdown phase is over, returns that respect the traditional term structure of interest rates begin to prevail again.
The attached graph shows the yield curves of some financially significant countries at the end of December 2023. The US and UK curves are positioned at a significantly higher level than those of the other European countries; this essentially depends on the tone of the monetary policy of their central banks, with a significantly higher reference rate. All the curves, to a more or less significant extent, have a U-shaped trend: decreasing in the first section, which reports short-term rates, and increasing in the terminal part. This signals expectations of a reduction in central bank policy rates, after the repeated increases in previous months, in a context in which inflation is falling rapidly. However, the central parts of the US, UK and German curves are flat, reflecting the uncertainty over the medium term that still weighs on investors' minds: will there be a recession or soft-landing? In the case of Italy, however, after an initial stretch of inversion, the curve resumes its normal trend. Italy has the curve with the steepest slope: the 10-year rate is about one percentage point higher than the 3-year rate, and the 20-year rate is one and a half points higher, while the corresponding gaps in the average of the euro area are equal to 0,3 and 0,7 points respectively. This is because for Italy the country risk is still significant, linked as it is to the state of public finances, which is also reflected in the spread of 10-year bonds with Germany, equal to around 165 basis points.
