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Explained: Yield curves, their various shapes and whether they can predict a recession

Explained: Yield curves, their various shapes and whether they can predict a recession

Explained: Yield curves, their various shapes and whether they can predict a recession
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By Ritu Singh  Jun 11, 2020 6:48:01 PM IST (Updated)

The yield curve is back in the news after the COVID-19 pandemic created an unforeseeable economic crisis globally.

The yield curve is back in the news after the COVID-19 pandemic created an unforeseeable economic crisis globally, prompting central banks to open their toolkit with which they can go about containing the downside.

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Among its various options, trying to manage the yield curve is one of the most important parts of any central bank’s plans. So what’s a yield curve, what does its behavior imply and what can central banks do to influence it, and thereby the economy? Here’s an explainer.
But before getting into technicalities, what is a bond and what is its yield?
Governments and companies around the world raise money by issuing bonds. The interest rate they pay to the bondholders is called the coupon rate. Assume a hypothetical company X borrows Rs 100 at a coupon rate of 10 percent. It may pay its bondholders Rs 5 every six months 5 times before paying Rs 105 at end of the tenure. All bondholders who keep the bond for the full duration will definitely get this amount unless the company defaults on its obligations.
However, not all bondholders want to hold the bond for that long. As a result, they are allowed to sell the bonds to others who want to buy and exit. Once the bonds are listed, their price (say a bond is listed at a face value of Rs 100) will go up or down depending on demand and supply, which is driven by fundamentals, the overall economic environment and sentiment. If the price goes down, the indicative loss is reflected in what is called the yield. (Prices and yield move in proportionate opposite directions.) If the yield on a bond is rising or is high, it means investors are seeking a higher interest rate to compensate for what they perceive to be rising or high risk. Which then brings us to...
What is a yield curve?
Bonds may be issued with varying maturities, ranging from a few months to 10 or even 30 years. Even with the same credit quality (or borrower), the yields on bonds with different maturity are different. This is because if you loan your money for shorter term, you may be willing to accept lower interest rates in return. But if you loan your money for a longer duration of say 10 or 20 years, then you are right to expect a higher return because you are parting with your money for a longer time. A lot of unforeseen events may transpire during that timeframe, and therefore the risks will also be higher. So the longer the duration of the loan, the higher is the expected return to make up for the risk. These are represented by different yields for the same bond having different maturities.
When you plot these yields available for bonds on the Y-axis of a graph, and the time to maturity on the X-Axis, what you get is a yield curve.
A yield curve, therefore, reveals the relationship between the interest rate and the time to maturity of a bond or security.
Which yield curve do investors or markets track most closely?
Any borrower’s yield curve can be traced by mapping the interest rates at which he/she can take loans from the market, for different time periods. However, what the markets and investors most commonly track is the yield curve of the government.
Just like in other countries, the Indian government borrows money from the market through auctions of treasury bills (T-Bill), and government securities (G-Secs). Typically, markets track the government yield curve by plotting the spread (or difference between short-term and long-term rates) between the one year and ten year market borrowings to arrive at the country’s yield curve. The government’s yield curve also sets the floor for all other borrowing rates, as government is perceived to be the least risky borrower.
What shapes can a yield curve take? Is a yield curve always upward sloping?
A yield curve can take three shapes: normal (upward sloping curve), inverted (downward sloping curve) and flat.
In an ideal world, one expects that the longer the duration of a given to the government, the higher the return due to associated risks, as explained before. If this was the case, then a yield curve would always be upward sloping, indicating that longer duration loans get higher yields.
Sometimes, the curve can be inverted. This happens when short term bonds are yielding higher returns than long term bonds.
A yield curve can steepen when long term rates rise faster than short-term rates. It can flatten when short term rates rise faster than long term rates.
What does the shape of the yield curve indicate?
The slope of the yield curve is a leading indicator of where the country’s economy is heading. This is so because the shape of the yield curve reflects investors’ expectations about future interest rates, and by extension, economic growth.
An upward sloping or normal yield curve may indicate that markets expect business-as-usual for the economy, no significant changes in inflation (price rise).
Strong economic growth often goes hand in hand with higher inflation. When an economy is growing, demand for money is higher because of higher spending activities. Higher demand for money drives up interest rates. Thus, in periods of economic expansion, investors expect the bond yields with longer-maturity to be higher than shorter-term because they expect future interest rates as well as inflation to be higher. Higher spread gives an upward sloping yield curve.
A downward sloping or inverted yield curve, on the other hand, shows that markets expect the economy to slow down and interest rates to drop in the future. When markets fear an economic slowdown, they expect demand for money to go down, which will drive interest rates lower. They also, thus, expect inflation to remain lower. Lower spreads, which is the difference between short term and long term yields, therefore results in a downward sloping yield curve.
A steep yield curve shows long-term bondholders expect the economy to improve quickly in the future. Therefore, as explained earlier, it also shows that bond markets expect prices to rise, or an inflationary trend.
A flat yield curve simply says that the market is at the point of inflection. From there, it could either go into either a recession or some economic pick-up. It indicates that activity is slowing down, and investors are uncertain about the future.
Did you say recession? Can the yield curve predict a recession?
There is some evidence that when an inverted yield curve appears, it is followed by a recession. Having said that, experts have warned that we are living in times of extraordinary monetary experiments globally, such as zero interest rates. Thus, such correlations cannot be expected to also hold in the future.
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