Have a View on the Shape of Yield Curve
By TJ Kim – Bondsquawk
October 25, 2012
One of many key essential ingredients in the top-down bond investment analysis is analysis on the shape of an yield curve. An yield curve is very simple. It plots yield (y-axis) and maturity (x-axis) of a bond and creates a connection that is shaped as a curve. Normally 10-yr U.S. Treasury bonds is widely used because the US Treasury yield curve is a fundamental benchmark for the fixed income market. Below is an example of an yield curve.
Usually, investors express their views on the shape of an yield curve in terms of “steepening” or “Flattening.” When a yield curve steepens, the gap between the yields on a shorter dated bond and a longer one is widening. On the other hand, flattening yield curve indicates that the gap between shorter dated bonds and longer ones are closing up.
Now, in order to express views on yield curves, it is important to understand some of macroeconomics metrics that we see and read every day on newspaper or tv.
First is US Monetary Policy, below is written by Federal Reserve Bank of New York on monetary policy and yield curves
“Monetary policy can influence the slope of the yield curve. A tightening of monetary policy usually means a rise in short-term interest rates, typically intended to lead to a reduction in inflationary pressures. When those pressures subside, it is expected that a policy easing—lower rates—will follow. Whereas short-term interest rates are relatively high as a result of the tightening, long term rates tend to reflect longer term expectations and rise by less than short-term rates. The monetary tightening both slows down the economy and flattens (or even inverts) the yield curve.”
Then, there is inflation expectation that can play a large role in setting yields for longer dated bonds. If inflation expectation is high in future, an investor in a bond will require a higher yield to secure the time value of their money locked in for the length of maturity. Therefore, on the onset of high inflation, a longer dated bond’s yield spikes up where as a shorter one does not move up as much – leading to steepening of yield curves.
According to Barclays, business cycle also influences the shape of a yield curve.
“The yield curve tends to steepen during the early stages of a macroeconomic downturn and flatten during the recovery stages. The curve may “invert” near the peak of an expansion (i.e., the yields available for shorter-term Treasury securities may temporarily exceed the yields available for longer-term Treasury securities).”
Original post can be found here
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