The Structure of Interest Rates and the Yield Curve
As you know, the close relationship between bonds and interest rates and how they can rise and fall in certain contexts of the economic cycle. The cost of money, represented by interest rates, is not always the same and changes according to the reference deadline. For example, the yield offered by a one-year bond is different from that offered by the same type of five-year bond.
What is the interest rate curve, and why is it useful for those who want to invest in bonds? Today, in this article, we will discuss the structure of interest rate and the yield curve if you still don't have a clear idea of what it is
What is the term structure of rates?
In a simplified way, we consider bonds of the same investment category (for example, U.S. government bonds) but with different maturities (from 3 months to 30 years). If we combine the points identified by the total return that the investor receives if he keeps the bond until maturity and the time remaining before maturity (residual life 1), we obtain the yield curve or term structure of interest rates.
This curve represents the relationship existing on a given day, according to the market, between the rate of return offered by an American government bond at a specific maturity and the maturity itself.
When you see the chart that shows the yield curve, then you will notice some points.
The first value, the first point of the line, is the spot interest rate, which is the rate for shorter maturity at three months, influenced more directly by the American central bank. Two important aspects when looking at the yield curve are the level of the curve and the shape.
The level of the interest rate curve
The level of the curve and its shifts may reflect the monetary policy behavior of the central bank. Consider the maneuvers of quantitative easing and, in general, of expansive monetary policy by the FED since the outbreak of the Great Recession of 2008. These moves have helped to move down the yield curve, reducing interest rates on the various maturities.
The slope of the rate curve
The slope of the yield curve is influenced by several factors, i.e., expectations, risk premia, and market segmentation/preferences. There are two main explanations for its performance, risk premiums, which investors require to invest in long-term bonds compared to short-term ones, and investors' expectations on future interest rates. These expectations, in turn, reflect what the market expects about:
- price trend
- the trend of the economy
- Central Bank behavior.
In short, the inclination of the curve is not easy to interpret.
Deadline and yield
An interest rate curve is a useful tool not only for market operators but also for individual savers. And expiry and yield are the fundamental elements for tracing the curve in question. We consider bonds of the same investment category (for example, our government bonds) but with different maturities. By connecting the points identified by the total return that the investor obtains if he keeps the obligation until maturity and the time that remains before the same maturity, the term structure of interest rates is obtained; in technical jargon, it is called the yield curve.
The level of the yield curve
The level of the curve and the relative movements, upwards or downwards, mainly reflects the monetary policy decided by the central bank of the reference country. The Quantitative Easing program, for example, launched by central banks to support the economy in the years of the crisis and which continues in most countries, has contributed to "crushing" the yield curve and, therefore to reducing the rates of interest on different deadlines.
The slope of the curve
The curves of interest rates are not all the same and can have different shapes and, therefore, different inclinations. The inclination is influenced mainly by two factors, i.e., the risk premium, which investors require to invest in long-term bonds compared to short-term ones, and expectations on future interest rates, the latter linked to inflation expectations. The possible forms that a curve can take based on the economic context are manifold.
The three types of the yield curve
The yield curve can take three typical forms, which we now analyze.
Short-term rates are approximately equal to long-term rates, which are usually highlighted with a blue line. This form may signal an expectation of a slowdown in economic activity. Such a curve is unusual and generally indicates a transition phase towards a positive or negative inclination.
In most cases, the "red" curve indicated a slowdown in economic activity in the country, and, actually, there is a recession due to a drop in consumption.
2: Negatively inclined
In this situation, as maturities increase, rates decrease that is highlighted with a green line. Financial markets expect short-term rates to be lower in the future. This form is indicative of a recessionary and/or deflationary economic phase and may reflect expansive monetary policy expectations.
Generally, this type of inclination does not last long. At the beginning of 2000, the yield curve was negatively inclined. About a year later, the American economy went into recession; marking the end of the period that Alan Greenspan had called "irrational euphoria."
3: Positively inclined
It is the normal inclination of the curve so that, as the due dates increase, the rates increase, which is usually highlighted with a yellow line. This is because long-term bonds are riskier, it is easy to understand that if an investor deprives of a sum today, he lends it and knows that he will be able to receive it back in many years, he will ask for a bigger premium.
The slope of the curve can also be explained by expectations; the financial markets expect higher short-term interest rates in the future. This inclination is indicative of an expansionary and/or inflationary economic phase and may reflect expectations of restrictive monetary policy (increase in interest rates).
Author: Vicki Lezama