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The significance of the yield curve

Terms like “yield curve” can be mind-numbing if one is not a bond trader, or may have not ran through the academic financial world, but the mechanics and practical impact of it are fairly straightforward.

First and foremost, the yield curve is a graphed line that represents the relationship between interest rates and maturities, specifically in government securities. Interestingly enough, financial participants give certain importance to the said yield curve, as historically it has been shown to be a good predictor for recessions.

Economists, market analysts and bond investors focus on studying significant interest rate changes closely, because they affect financing costs and hence, expenditure decisions of both businesses and consumers across all market sectors.

The yield curve plots the yield return on the y-axis and the maturity on the x-axis. The resulting line is usually asymptotic - that is, it initially curves upward but then flattens out the farther the line extends. Short-term interest rates are determined by the federal funds rate that the Federal Reserve sets, but long-term interest rates are largely determined by the market. As said, looking at the yield curve reveals the current market consensus and the likely future direction of both interest rates and the economy.

Generally, an upward sloping yield curve is taken as an indication of the likelihood that the Federal Reserve will raise interest rates in an attempt to control inflation. An important, yet laborious terminology is the inverted yield curve, which basically is a situation where the short-term interest rates are yielding higher than longer term maturities. On the other hand, a flat yield curve indicates that the market consensus is that the Federal Reserve may be cutting interest rates somewhat to stimulate the economy but, unless there are further indications of possible deflation, it will not cut rates aggressively.

What are we experiencing?

This year, the Fed announced that it raised its inflation target to 2 per cent. In doing so, it was expected that there would be three interest rate hikes within this year and in fact, short-term rates have been rising. Apart from the gap being under pressure by the re-ignited trade war, the interest rate hikes have led the yield curve to flatten i.e. the gap between short-term interest rates and long-term interest rates has been shrinking and in fact reached an all-time low of 26.556 basis points. In 2007, the yield curve was at this level and it was at that time that the US experienced the worst recession in almost 80 years.

As a consequence of interest rate hikes the bond market was highly sensitive, primarily when the 10-year Treasury breached the 3 per cent levels. Short-term borrowing costs have been pushed to levels that make certain trades less appealing specifically when borrowing for longer periods.

Fed looks for alternative signals

At the Fed’s June meeting, new research from staff economists Eric Engstrom and Steven Sharpe was presented. It was suggested that some of the traditional warning signs of recession, such as the gap in interest rates between 2-year and 10-year Treasuries, may not be as influential as an analysts focus on shorter term rates.

In particular, they found that the difference in current interest rates on 3-month Treasury bills and those expected in 18 months served as a stronger predictor of recession in the coming year by capturing the market’s conviction that the Fed would need to cut rates soon in response to a slowdown. In fact, this has prompted some Fed officials to already call for a halt to rate hikes.

It is to be noted that even though flattening is occurring, it would become alarming only if it keeps moving in this direction as one will see that eventually, long-term interest rates will be below short-term interest rates. Should the Fed indeed halt interest rate hikes, the yield curve should stabilise and lead markets to recover; long-term rates will not fall below short-term rates and we should see bond prices increasing once again.

Given the recent market movements triggered primarily by the trade war uncertainty, one should opt for a cautious approach. We have experienced such movements in the past and despite many market participants believe that the bond market is at the end of the cycle, the recent uncertainty might relax such preposition.

Disclaimer:

This article was issued by Maria Fenech, investment management support officer at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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