The yield curve and its relevance to the stockmarket

CFD traders will often hear the phrase ‘yield curve’ used in long and short term evaluation of investment trends, and it is seen as important as one barometer for the outlook for the economy, and thus the stockmarket. The curve itself shows the structure of interest rates plotted over different maturities as measured by government bond prices, from the shortest dated bonds, which usually are related to short term interest rates, to long-dated i.e. 30 year plus maturities.

This enables investors firstly to be able to compare the yields offered by short-term, medium-term and long-term bonds. As there is usually a higher risk involved in choosing a longer dated maturity, typically the yield curve should slop upward, but it is the actual slope that is of interest. This also has relevance for forex investors as it reflects one part of longer term currency risk evaluation.

The three shapes of the curve

The yield curve usually takes one of three shapes. If short-term yields are lower than long-term yields, the line of interest rates will slope upwards, and this is seen as normal.

If short-term yields are higher than long-term yields, the line then slopes down (at least at the beginning), and this is referred to as an inverted or negative yield curve.

Occasionally, a flat yield curve reflects hardly any disparity between short-dated and long-dated yields.

What bonds are plotted?

It is very important that only bonds of similar risk are plotted on the curve, as the gap between low and high risk bonds itself is another factor for longer term investors to examine when choosing investments. In the US, the most common type of yield curve plots Treasury securities because they are considered risk-free and are used as a benchmark for determining the yield on other types of higher risk debt. The yield curves are calculated and published by The Wall Street Journal, the Federal Reserve, and a variety of other financial institutions.

In the UK, gilt stocks are used in the same way and it is simple to compile current yield curves from the Financial Times.

The importance of the yield curve

As mentioned above, when the yield curve is positive or sloping upwards, this indicates that investors require a higher rate of return for the added risk of lending money for longer periods of time, which is normal.

If the yield curve shows a steep upwards slope, this indicates to some commentators that investors are looking at strong future economic growth and potentially higher future inflation, which might lead to higher interest rates.

Changes in the shape of the yield curve can also have an impact on portfolio returns by making differently dated bonds more or less valuable relative to other bonds, so analysts and investors need to study yield curves carefully.

If there is a flat curve this generally indicates that investors are unsure about future economic growth and inflation.

The inverted yield curve

This has been quite topical in recent months as inverted yield curves have been seen in many economies after the period of steadily tightening monetary policy up until this summer.

Where there is an inverted yield curve this suggests that investors expect slowing economic growth and potentially lower inflation. The inference here is lower interest rates to stave off possible recession, and this is what we have seen in the US earlier this month when the Federal Reserve lowered rates by 50 basis points.

There have been many studies that have found that inverted yield curves tend to precede recessions, but this may be subject to revision given the prevailing fiat monetary policies in much of the developed world currently.

Yield curve theory

There are three main theories that attempt to explain why yield curves are shaped the way they are, and it is for the long term investor to decide whether these are relevant or superfluous to the prevailing shape of the curve.

The expectations theory states that expectations of rising short-term interest rates are what create a positive yield curve and vice versa.

The liquidity preference hypothesis states that investors always prefer the higher liquidity of short-term debt and therefore any deviance from a positive yield curve will only prove to be a temporary phenomenon.

The segmented market hypothesis states that different investors confine themselves to certain maturity segments, making the yield curve a reflection of prevailing investment policies.

About the Author:

Mike Estrey is the Head of Research for Blue Index, the Day Trading specialists in Contracts for Difference. Foreign Exchange Trading also forms part of their extensive services.