Yield Curve Explained – MBA Mondays

by Darwin on February 28, 2011

The yield curve is explained in this week’s MBA Monday topic.  For years, I used to hear about “the yield curve” and remain disinterested because I thought stocks were so much cooler than bonds.  Bonds were for old farts, right?  What I’ve come to learn after an MBA and witnessing the near collapse of the financial system is that everything I thought about bonds was either wrong, or a result of naivety.  The yield curve is one of those measures my old professor used to say would allow you to “listen to what the market is trying to tell you”.  Bond yields, spreads and curves don’t always make the cover of the mainstream money mags at the bookstore and most bloggers aren’t pitching their favorite bonds.  But the data gleamed from bonds, relationships with other bonds and trends can be very prescient in predicting everything from inflation to recessions to defaults.

The Yield Curve Explained

The yield curve, more formally referred to as the “Term Structure of Interest Rates” is essentially an assessment of interest rates over time, usually starting with the shortest duration rates on the left and the longest off to the right.  If you’re familiar with anything from CD rates to mortgage rates, you always either get paid more, or have to pay more for longer duration terms, right?  I mean, who would open up a 5 year CD if a 6 month CD had a higher annual interest rate?  And would you ever bother with a 15 year mortgage if the interest rate was no lower than a 30?  So, due to inflation, risk and other factors, bonds USUALLY behave in this manner, with longer duration bonds commanding a higher rate.  But sometimes they don’t!  More on that later.  Here’s an example picture of the yield curve for US Treasuries:

This is just touching the surface.  Not only do we expect the yield curve to slope upward over time, but there are measures of the steepness of the curve, changes in the term structure over time, flattening of the curve and other behaviors that show what the market is pricing in – which is sometimes different than what stocks or Jim Cramer are telling you.

What Makes the Yield Curve Move?

In order for the yield curve to steepen further, investors expect the economy to continue to improve, such that the price of bonds will drop, thus increasing their yields.  Bond prices would drop because presumably, money will shift into risk assets like stocks and also because one would expect the Fed to have to raise interest rates to quell inflation that arises during periods of low unemployment and high economic growth.  But…the yield curve steepening could also be a sign of just plain future inflation without a strong economy.  After all, near-term interest rates can’t go much lower right? The Fed is already giving away money for free.  So, in a future with hyperinflation, investors would be expecting to be compensated with much higher interest rates further out into the future as well.  Conversely, interest rates CAN actually drop in the outer years…

Inverted Yield Curve

The inverted yield curve is a rare case where bond yields actually drop in the outer years, defying conventional wisdom – but without defying logic.  See, the bond market sometimes predicts a coming Recession, knowing full-well that the Fed will inevitably drop interest rates when the economy weakens.  This is what happened during the most recent “Great Recession” and virtually every other recession in history (at least one exception in the literature last century).  As late as 2007, the press was saying that “it was different this time” (USA Today) and the inverted yield curve that existed was being influenced by external factors like China and others.  But alas, it wasn’t different.  We had a helluva Recession.

While you may or may not have found this topic to be interesting, there are entire disciplines dedicated to the study, trading, arbitrage, and making predictions based on the yield curve.  Make sure to check out the other MBA Monday topics with Darwin.

{ 2 comments… read them below or add one }

101 Centavos March 1, 2011 at 7:40 am

Good article, Darwin. Always enjoy MBA Mondays. It took me a while to understand the relationship between bond prices and yields, but when I finally did, the proverbial light bulb lit up ( and then out, it was one of them new CFL bulbs ).

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Evan March 3, 2011 at 3:25 pm

This is why it is annoying to listen to Economists…its all 20/20 hindsight. Was there any accountability for those analysts who said “Nah, don’t worry about it, we’ll be fine lol” I am going to guess no (well unless they worked for BSC or Lehman)

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