Yield Curve

The yield curve plots the return on various fixed income instruments. The shape of the curve illustrates the relationship between expected yields and time to maturity. Bond yields are based on the duration of the bond (i.e. the time to maturity) and the creditworthiness of the issuer. In order to attract investors, long-term bonds must offer higher returns as they are as risk of losing value through a diminishing of the liquidity spread.

Liquidity spread is the difference between bond yields and short-term interest rates. As interest rates rise, the locked-in yield of a bond becomes less valuable as it does not adjust higher to compensate for the rising interest rates, thereby reducing the true value of the return. If short-term interest rates rise above the yield, the investor actually has a negative liquidity spread.

Normal Yield Curve

A so-called “normal” yield curve is one that curves upwards in a concave manner. This indicates an increase in the yield (the x axis) as time to maturity (the y axis) increases. This follows the tenant of the Arbitrage Pricing Theory that states that the longer the term to maturity, the higher the yield. This rewards investors willing to lock their money into long-term bonds despite the increased risks noted earlier.

Flat Curve

A flat yield curve results when the yields are basically the same for all maturities. This indicates that investors are willing to accept yields on long-term instruments that do not include a premium above current short term yields. Investors would only accept this if they feel that the economy has little capacity for growth combined with the likelihood that short-term interest rates will not rise.

Inverted Yield Curve

An inverted yield curve that slopes downwards over time indicates a negative outlook for the market in the future and could suggest the onset of a prolonged economic downturn or possible recession. An inverted yield curve shows even greater long-term pessimism than a flat curve – so much so that long-term bond yields actually fall below short-term yields (negative liquidity spread). The implication is that investors are willing to lock in investments at the current rate in the belief that yields will lower dramatically in the face of a worsening economy.

Humped Curve

A “humped” curve occurs when both short and long yields are equal but medium-term yields are higher. This could indicate an expectation that the economy may be entering a period of growth but this growth is not expected to be sustainable for the long-term.

Market Relevance

Very High

Volatility

Moderate for stocks and bonds – High for FX