Yield Curve

From wikipedia.com

In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given Currency. For example, the current U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely watched by many traders, and are commonly plotted on a graph such as the one on the below which is informally called "the yield curve.

The US dollar yield curve as of 9 February  2005. The curve has a typical upward sloping shape.

The yield curve describes the relationship between various short- and long-term interest rates (i.e., the "term structure"), and is often represented as a graph showing the duration of investment on the x-axis and the annualized interest rate on the y-axis.

The yield curve is important because many banks and financial institutions' profits are tied to the difference between short-term and long-term interest rates (the yield curve) rather than whether interest rates are low or high.

Theory

Suppose an investor had a dollar he wanted to invest for ten years. One option would be to invest it in a 10-year bond that would pay some known interest rate for all ten years. Another option would be to put the money in a savings account; although today's interest rate is known, the investor could not be sure what return he would earn tomorrow, or any other day over the duration of the investment. For an investor to decide whether it was a better idea to invest in the bond or the savings account, he would need to:

1. form some expectations about what interest rate the savings account would offer in the future, and
2. decide how important it is for him to "lock in" an interest rate today, versus taking a chance that the return on his savings account could decline in the future.

The forces of supply and demand ensure that long-term interest rates adjust based on borrowers' and lenders' expectations of future interest rates, as well as their attitude towards interest rate risk (i.e., how much they value locking in a long-term interest rate today).

Practice

In general, the yield curve is "upward sloping"; that is, long-term interest rates are higher than short-term interest rates (a positive interest rate spread ).

When long-term interest rates become especially high relative to short-term rates, we speak of a steep yield curve, or a high interest rate spread.

When long-term rates are especially low, we refer to a flat yield curve; at the extreme, short-term rates may be even higher than long-term rates, a situation referred to as the (often dreaded) inverted yield curve.

The British pound yield curve as of 9 February 2005. This curve is unusual in that long-term rates are lower than short-term ones.

Changes in the shape of the yield curve are important for equity investors for two main reasons:

Macroeconomic indicator

Interest rates are important for the economy in many ways, and the shape of the yield curve depends critically on expectations of future interest rates. Many forecasters believe that an inverted yield curve (where short-term rates exceed long-term rates) in particular signals degrading future economic conditions.

Carry trade

Many financial services companies borrow money at short-term rates (for example, paying low savings-account interest rates to their depositors), and lend at long-term rates (for example, through mortgages). In a typical upwards-sloping yield curve environment, this can be a source of significant profit for banks, since they collect interest at high rates but only pay low short-term rates. As the yield curve flattens (or even inverts), this source of profit disappears. Thus financial service companies' profitability often suffers when the yield curve flattens.

Going Forward

Of course, nothing ever stays the same in the market, and going forward, the yield curve will either steepen or become more inverted. Who is likely to win in each case?

Housing and mortgage companies are likely to incur losses if the curve flattens, since mortgage rates are typically tied to the yield on the 10-year Treasury. Home builders decline, since higher mortgage rates will mean less demand for new home building. On the other hand, banks which own large institutional bond funds, will likely gain if the curve becomes further inverted.

Meanwhile, technology companies are likely to benefit from a steepening curve, since a rise in long-term rates would mean that investor sentiment has improved, and that consumers are therefore more likely to show more discretionary spending.