Yield Curve and its importance

If you invest in equities, you should keep an eye on the bond market. If you invest in real estate, you
should keep an eye on the bond market. If you invest in bonds, you should definitely keep an eye on the
bond market! The bond market is a great predictor of future economic activity and future levels of
inflation, both of which directly affect the price of everything from stocks and real estate to household
items. This article discusses short-term versus long-term interest rates, the yield curve and how to use
the study of yields to your advantage in making a broad range of investment decisions.

Short-Term Versus Long-Term Rates and Yields

When speaking of interest rates (or yields), it is important to understand that there are short-term
interest rates, long-term interest rates and any number of points in between. While all interest rates
are correlated, they don't always move in step. For example, short-term interest rates might decrease,
while long-term interest rates might increase, or vice versa.

Short-Term Interest Rates

Short-term interest rates worldwide are administered by the nations' central banks. In the United
States, the Federal Reserve Board's Open Market Committee (FOMC) sets the federal funds rate, the
benchmark for other short-term interest rates. The FOMC raises and lowers the fed funds rate
(monetary policy) as it sees fit to promote or curtail borrowing activity by businesses and consumers.
Borrowing activity has a direct effect on economic activity. If the FOMC finds that economic activity is
slowing, it might lower the fed funds rate to increase borrowing and stimulate the economy. However,
the FOMC must also be concerned with inflation. If the FOMC holds short-term interest rates too low
for too long, it risks igniting inflation by injecting too much money into an economy that is chasing
after fewer goods.

Long-Term Interest Rates

While short-term interest rates are administered by central banks, long-term interest rates are
determined by market forces. Long-term interest rates are largely a function of the effect the bond
market believes current short-term interest rates will have on future levels of inflation. If the bond
market believes that the FOMC has set the fed funds rate too low, expectations of future inflation
increase, which causes long-term interest rates to increase in order to compensate for the loss of
purchasing power associated with the future cash flows of a bond or the principal and interest
payments on a loan. On the other hand, if the market believes that the FOMC has set the fed funds
rate too high, the opposite happens - long-term interest rates decrease because the market believes
future levels of inflation will decrease.
Use the Yield Curve to Help Make Top-Down Investment Decisions
Interpreting the slope of the yield curve is a very useful tool in making top-down investment decisions.
For example, it is normal for the yield curve to be positive (upward sloping, left to right) simply because
investors normally demand compensation for the added RISK of holding longer-term SECURITIES.
Moreover, from an upward sloping yield curve you can also foresee an inflationary pressure (expected
inflation) and higher growth (business cycle expansion). Historically, a downward-sloping (or inverted)
yield curve has been an indicator of RECESSION on the horizon, or, at least, that investors expect the
CENTRAL BANK to cut short-term interest rates in the near future. A flat yield curve means that
investors are indifferent to maturity risk, but this is unusual. When the yield curve as a whole moves
higher, it means that investors are more worried that INFLATION will rise for the foreseeable future
and therefore that higher interest rates will be needed. When the whole curve moves lower, it means
that investors have a rosier inflationary outlook.

Conclusion
The yield curve can help make a wide range of financial decisions. The yield curve reflects the bond
market's consensus opinion of future economic activity, levels of inflation, interest rates and level of
economic output. It's very difficult to outperform the market, so prudent investors should look to
employ valuable tools like the yield curve whenever possible in their decision-making processes.
 The Yield Curve as a Leading Indicator: Some Practical Issues

Arturo Estrella and Mary R. Trubin

Volume 12, Number 5 July/August 2006

FEDERAL RESERVE BANK OF NEW YORK
www.newyorkfed.org/research/current_issues

Since the 1980s, economists have argued that the slope of the yield curve—the spread
between long- and short-term interest rates—is a good predictor of future economic
activity. While much of the existing research has documented how consistently
movements in the curve have signaled past recessions, considerably less attention has
been paid to the use of the yield curve as a forecasting tool in real time. This analysis
seeks to fill that gap by offering practical guidelines on how best to construct the yield
curve indicator and to interpret the measure in real time.

Before each of the last six recessions, short term interest rates rose above long-term rates, reversing
the customary pattern and producing what economists call a yield curve inversion. Thus, it is not
surprising that the recent flattening of the yield curve has attracted the attention of the media and
financial markets and prompted speculation about the possibility of a new downturn. Since the 1980s,
an extensive literature has developed in support of the yield curve as a reliable predictor of recessions
and future economic activity more generally. Indeed, studies have linked the slope of the yield curve to
subsequent changes in GDP, consumption, industrial production, and investment.

Conceptual Considerations
The literature on the use of the yield curve to predict recessions has been predominantly empirical,
documenting correlations rather than building theories to explain such correlations. This focus on the
empirical may have created the unfortunate impression that no good explanation for the relationship
exists—in other words, that the relationship is a fluke. In fact, there is no shortage of reasonable
explanations, many of which date back to the early literature on this topic and have now been
extended in various directions. For the most part, these explanations are mutually compatible and,
viewed in their totality, suggest that the relationships between the yield curve and recessions are likely
to be very robust indeed. We give two examples that emphasize monetary policy and investor
expectations, respectively.
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.
Changes in investor expectations can also change the slope of the yield curve. Consider that
expectations of future short term interest rates are related to future real demand for credit and to
future inflation. A rise in short-term interest rates induced by monetary policy could be expected to
lead to a future slowdown in real economic activity and demand for credit, putting downward pressure
on future real interest rates. At the same time, slowing activity may result in lower expected inflation,
increasing the likelihood of a future easing in monetary policy. The expected declines in short-term
rates would tend to reduce current long-term rates and flatten the yield curve. Clearly, this scenario is
consistent with the observed correlation between the yield curve and recessions.
The multiplicity of channels through which the predictive power of the yield curve may manifest itself
makes it difficult to give one simple explanation for that power. However, it also suggests a certain
robustness to the relationship between the yield curve and economic activity: if one channel is not in
play at any one time, other channels may take up the slack.
The conceptual relationships outlined here also have implications for the signals provided by the yield
curve indicator. First, the fact that long-term investor expectations figure so importantly in these
relationships means that the yield curve may be more forward-looking than other leading indicators. In
other words, the recession signals produced by the yield curve may come significantly in advance of
those produced by other indicators.
Second, the signals provided by the yield curve may be very sensitive to changes in financial market
conditions. The precise effect of these changes on the yield curve will depend on whether they stem
from technical factors or economic fundamentals. For example, because different maturities of fixed
income securities appeal to different clienteles, a permanent shift in the relative importance of
clienteles could produce permanent shifts in the slope of the yield curve. Alternatively, a temporary
change in the demand for assets of a given maturity— say, a change resulting from hedging activities—
could affect the slope of the yield curve for a short time before the yield curve returns to values
determined by economic fundamentals. These considerations suggest that the signals produced by the
yield curve must show some degree of persistence if they are to be meaningful, an issue to which we
return below.