Saturday, October 31, 2009

Meaning of the yield curve

A lot of discussion about economics today mentions the importance of the steep yield curve. Some even make predictions about what will happen next, giving the yield curve as evidence. But what is the meaning of a steep yield curve?

The Yield Curve Today

First, a refresher, what is the yield curve? As with most things, Wikipedia has a great article on the topic, so I'll just borrow from them:
The yield curve is the relation between the interest rate and the time to maturity of the debt. The yield of a debt instrument is the overall rate of return available on the investment. For instance, a bank account that pays an interest rate of 4% per year has a 4% yield. Investing for a period of time t gives a yield Y(t). This function Y is called the yield curve, and it is often, but not always, an increasing function of t.
The slope of the yield curve tells us how quickly the yield increases as the term increases. A quick way of checking this slope is to compare the yield of the 10 year treasury note to that of the 2 year note. The following graph shows how this value has changed over the last 20 years.

The current value, 2.49%, is much higher than the average, 1%. In fact it is about as high as it has ever been over the last 20 years. This qualifies as a steep yield curve.

What does it mean?

Negative sloping yield curves are reasonably accurate predictors of recession and steep yield curves are predictors of strong economic growth. As you can see in the graph above, the yield curve was almost flat throughout the mid-90s indicating a risk of economic weakness. Arguably this risk manifested itself as the tech sector crash in early 2000. During parts of 2005-2006, preceding the current recession, the yield curve was negative.

A steep yield curve is generally considered to be a predictor of strong economic growth. The yield curve was steep coming out of the recessions in the early '90s and 2000s. Since the yield curve is just as steep now as it was then, does this mean we are out of the woods and can look forward to strong growth?

As the economy heats up, inflation will generally increase. Most central banks will try to keep inflation within a (low) controlled range. They will adjust monetary policy to this effect. The most commonly employed method of keeping high inflation in check is increasing the lending rate. A steep yield curve represents and adjustment for the risk of higher interest rates in the future, which implies economic growth.

But there are other potential causes for inflation. Some argue that the steep curve is adjusting for the risk of inflation due to the massive stimulus the government has injected into the economy through the policy of quantitative easing the US Federal Reserve applied in 2008-2009. If this turns out to be correct, we could have inflation without recovery.


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