Yield curves talk only with their body language. So you need an interpreter who can decode their message. Some people specialize in analysing every move of yield curves. They try to figure out whether the market is on the verge of a recession or an economic boom. Our friend Johnny does not belong to this tribe of curve gazers. But he is interested in knowing why yield curves arouse so much interest.
Let’s see what our friends are chatting about today:
Johnny: Hi, Jinny! I see you are busy with a sheet of paper. What are you up to?
Jinny: Well, Johnny, I have found a new game that looks better than the game of snakes and ladders. On this paper, there are several dots which you have to connect with a line. Once you connect all the dots, you will find something that looks like a curve. Tomorrow, these dots may shift to different spots. So tomorrow you may have a curve with a different look. The real challenge before you is to guess what this curve will look like in the coming days. You win if you are able to predict the shape correctly; otherwise, you lose. This whole game is called the game of yield curve.
Illustration: Jayachandran / Mint
Johnny: Wait a minute. Are you talking about the same yield curve that financial pundits talk about? I will be able to understand your game better if you first clarify what exactly is a yield curve.
Jinny: Let’s talk about the basics first. Yield curve is a graphical representation of interest rates of different maturity periods. Like any graph, you require two axes or variables to draw a yield curve. One of your axes is interest rate, which varies for different maturity periods. For instance, a short-term loan may carry less interest than a long-term loan. Your second axis is the time to maturity, which you can divide into different periods such as three months, one year, five years, 10 years, and so on. Now you plot the prevailing interest rate against the respective maturity period by putting a dot. You connect all the dots by a line to get the yield curve. The yield curve can have three main types of shapes, depending upon the prevailing interest rates. It can be upward sloping, downward sloping or flat. Some people greatly enjoy interpreting the shape of the yield curve for predicting the shape of things to come tomorrow.
Johnny: How do people analyse the shape and size of the yield curve? What kind of forecast can come out of that?
Jinny: The shape of the yield curve can indicate future interest rates and economic activity. An upward sloping yield curve is one in which long-term interest rates are higher than the short-term rates. An upward sloping yield curve is also called normal yield curve because, under normal circumstances, long-term interest rates should be higher than the short-term rates. This is so because locking money in for longer periods entails greater risk for the lender and, hence, he expects higher interest rates. It is believed that a normal yield curve shows that the demand for long-term investments is healthy and hence chances are that the economy is headed on a growth path.
However, a downward sloping yield curve, which is also called an inverted yield curve, is one in which short-term rates are higher than the long-term rates. In such a scenario, we could very well see a decline in long-term investments, which could be a sign of a looming recession.
In between the upward and downward slopes, you can also have a flat yield curve, in which the short-term rates are very close to long-term rates. A flat yield curve may indicate a transition phase for the economy.
Historically, it has been observed that recessions are preceded by inverted yield curves. However, history may not always repeat itself. So, be careful while relying on coded signs of yield curves.
Johnny: The inverted yield curve?has?puzzled?me?the?most. Why would anybody invest for longer maturity if the long-term interest rates are lower than the short-term ones?
Jinny: You need to take a look at another aspect. Suppose you want to invest your money for two years but the interest rate on lending for one year is higher than that for two years. If you go by common sense, it would be advisable to invest your money for one year and then renew it again for another year after the first year. This strategy can work well only if the interest rates remain stable or continue to rise during the year. If, after one year, rates fall steeply, your reinvestment after the first year may not give you good returns. After one year, you may be worse off. So, it is better to take what is certain today than to wait for something that is uncertain tomorrow.
Johnny: I think uncertainty of outcomes makes your game of yield curves more interesting than the game of snakes and ladders.
What: A yield curve is a graphical representation of interest rates of different maturity periods.
How: A yield curve is drawn by plotting the prevailing interest rate against the respective maturity period with a dot, and connecting all the dots by a line.
How many: Yield curves can have three main types of shapes: upward sloping, downward sloping or flat.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at firstname.lastname@example.org