Yield Curve Essay Example

a graph, we typically see an upward slope in the yield curve, which means that longer maturities tend to have higher returns. However, there are times when short-term yields exceed long-term yields, resulting in a downward slope known as a negative (or inverted) yield curve. Negative yield curves have been reliable predictors of future recessions. This prediction is particularly accurate when the fed funds rate is high, indicating a tight monetary policy.

• A flat yield curve is a moderate bear signal for equity markets. Banks suffer from a margin squeeze, as they pay mostly short-term rates to depositors while charging long-term rates to borrowers, and are reluctant to extend new credit.
• A negative yield curve is a strong bear signal. Normally caused by the Federal Reserve raising short-term interest rates to slow the economy, investors may contribute by driving long-term yields down -- switching out of equities into more secure investments.
• A steep yield curve is generally bullish for stock investors.

The Federal Reserve has the power to lower short-term interest rates in order to stimulate the economy. As a result, investors may decide to switch their investments from bonds to equities, causing long-term yields to rise. When policy is tightened, what happens to long-term rates? The dilemma lies in the fact that explaining this phenomenon is both rare and difficult. How unusual is it for long-term interest rates to decrease when monetary policy is being tightened? One approach is to analyze what happened to long-term rates during previous periods of policy tightening.

When the monetary policy is

tightened, interest rates are raised and bonds are sold to the public through open market operations. Additionally, the reserve requirement ratio is increased. Prior to this tightening, the yield curve had a steep upward slope, with long-term rates considerably higher than the federal funds rate. During tightening periods, short-term rates typically increase more than long-term rates. Although there may be instances where long-term rates decrease while short-term rates rise, this usually occurs towards the end of the tightening cycle rather than at its onset.

The current episode is unique because, instead of declining at the end of a tightening cycle, long-term rates have actually decreased at the beginning. As a result, the yield curve will shift its pivot point to the start of the tightening cycle. This phenomenon, known as rotation, involves short-term rates revolving around a relatively fixed long-term rate, resulting in a flattening and eventual inversion of the yield curve during policy tightening. Conversely, shifting occurs when all rates (short-term, medium-term, and long-term) move by similar proportions, causing the entire yield curve to parallelly shift upward during policy tightening. Shifting is linked to larger increases in long-term rates. It's important to note that there is a common misconception that monetary policy enables authorities to control all interest rates.

The monetary authorities only have control over the overnight rate, known as the monetary authority funds rate. They want to understand how a change in short-term rates will impact medium-term and long-term rates because these rates determine the borrowing costs for individuals and businesses, which ultimately affect the overall demand in the economy.

The yield curve displays the relationship between different bond

interest rates based on their time durations. It demonstrates the connection between short-term, medium-term, and long-term rates at a specific moment. Typically, the yield curve is represented by an ascending line that starts with lower interest rates for shorter-duration bonds and increases towards higher rates for longer-duration bonds. According to Fuhrer and Moore (1995), economists believe that the monetary authority manages the short end of the yield curve, which is referred to as the monetary authority funds rate. This management is carried out in response to macroeconomic shocks in order to achieve policy objectives of maintaining low and stable inflation while attaining maximum sustainable output.

The short end of the yield curve is influenced by macroeconomic variables, which define the state of the economy. These variables also impact expectations about future short-term interest rates, which in turn affect long-term interest rates. Determining long-term interest rates involves considering factors such as expectations of future inflation, economic activity, and the path of the monetary funds rate. Therefore, macroeconomic variables and modeling exercises are expected to be informative for explaining and predicting yield-curve movements. However, standard macroeconomic models did not incorporate long-term interest rates or the yield curve until recently. Wu (2001) conducted a study that examined how monetary policy "surprises" by the monetary authority affected the movement of the "slope" factor of the yield curve. The study used various methods to identify these surprises in order to ensure a robust analysis. The results revealed a strong correlation between such monetary policy surprises and changes in the slope factor over time.

The findings reveal that the actions of the monetary authority in monetary policy have a

temporary yet strong impact on the "slope" factor. These actions account for 80% to 90% of changes in the "slope" factor, but their effects typically diminish within one to two months. Moreover, unexpected adjustments in monetary policy do not result in significant changes to the "level" factor. This indicates that during this timeframe, the primary influence of the monetary authority on the yield curve is through modifying its slope. Recent literature generally agrees that macroeconomic variables, particularly monetary policy, consistently affect the slope of the yield curve.

When monetary policy is tightened, short-term interest rates initially rise but then decrease due to their anti-inflationary effects. This pattern is also seen in long-term rates, which only experience a slight increase. As a result, when contractionary monetary policy shocks occur, the slope of the yield curve decreases. The differing conclusions reached by Ang and Piazzesi (2001) and Evans and Marshall (2001) regarding the influence of the macroeconomy on changes in the yield curve level indicate an interesting area for further research.

The impact of the macroeconomic structure on long-term interest rates or the level of the yield curve is surprisingly little. Long-term nominal interest rates are composed of expected long-run inflation and long-term real interest rates. Therefore, any structural changes in the macroeconomy that affect long-run expected inflation or long-term real interest rates will have a significant effect on the "level" factor. For instance, in a monetary regime that targets inflation, alterations in the market's perception of the inflation target directly alter the level of the yield curve. The most influential factor that shapes the yield curve is monetary policy and market expectations regarding future

policy. The actions taken by the monetary authority have a major impact on both the short-end and long-end of the yield curve.

The monetary authority affects the short-end of the yield curve by adjusting the monetary funds rate. This rate is the interest rate that banks charge each other for overnight loans. The monetary authority can control this rate by changing the amount of money supply in the banking system. When they want to raise the funds rate, they sell Treasuries to banks and brokerages, reducing the money supply and forcing them to pay for bonds, which decreases their available cash holdings.

The monetary authority can increase the money supply by purchasing Treasuries from financial institutions. This action affects the funds rate, which in turn leads to changes in interest rates on other short-term securities. Financial institutions depend on borrowed money to maintain their inventory of notes and bonds. When the funds rate is at 6.0%, it becomes costly for financial institutions to borrow money for holding their inventory. As a result, they are less likely to hold securities with yields lower than 6.0% due to negative carry. The control of the monetary authority over the funds rate has a significant impact on short-term interest rates, thus influencing the yield curve.

When the market expects a decrease in the funds rate, short-term maturities outperform long-term maturities because short-term interest rates decline faster. Conversely, when the central bank raises interest rates, shorter maturities see a faster increase in yield (primarily due to financial institutions' concerns about negative carry situations and investors' belief that they can delay purchasing short-term securities to receive higher interest

rates on their investments). As a result, in this situation, shorter maturities have weaker performance compared to long-term maturities.

The primary impact the monetary authority has on the yield curve is by adjusting the fed-funds rate. Additionally, long-term interest rates are also significantly influenced by the monetary authority. Unlike short-term rates, long-term rates are less affected by negative carry concerns due to a longer timeframe for potential change. Essentially, long-term interest rates mirror future short-term interest rates and demonstrate how the monetary authority affects them.

The monetary authority has a crucial role in impacting long-term interest rates, mainly through inflation expectations. Inflation expectations are the main factor determining long-term interest rates, and the monetary authority influences these expectations through its policy actions. When the monetary authority is seen as actively fighting inflation, the market expects low inflation. As a result, long-term interest rates stay low since investors only demand a small premium above the inflation rate.

The monetary authority's impact on the demand for a higher interest rate to counter inflation risk can affect the market. This, in turn, may reduce investment returns and showcases the considerable influence of the monetary authority on the yield curve. Understanding the factors that shape the yield curve enables bond investors to make more informed decisions when selecting bonds with suitable maturities considering different yield curve conditions.

Investing in longer maturities will yield better results than investing in shorter maturities when the yield curve flattens. Prioritizing increasing exposure to the longer-end of the yield curve in this scenario will lead to higher returns on fixed income investments compared to passively ignoring the shape of the

curve. A flat yield curve is often a sign of an economic slowdown, typically caused by central banks raising interest rates to control rapid economic expansion.

The increase in short-term yields is a result of the rate hikes, while the decrease in long-term rates can be attributed to expectations of modest inflation. A yield curve that appears flat is not common and generally indicates a shift toward either an upward or downward sloping curve. When short-term bond yields surpass long-term bond yields, an inverted yield curve may serve as an early indication of an upcoming recession. This implies that investors are anticipating a reduction in interest rates, typically accompanied by an economic slowdown and decreased inflation.