What is the Yield Curve?
Before understanding a yield curve, you must understand yield, which is the interest rate you would receive if you invested in a bond.
Let’s use the example of a Fixed Deposit (FD) offered by a bank. Just like bonds, an FD offers fixed interest. When you visit a bank to open an FD, you will likely look at the interest rate chart. This chart shows that the shorter the period you agree to keep your money with the bank, the lower the interest rate you will earn.
For instance, in the current scenario, if you deposit your money for 180 days (6 months), you might earn around 5.25% interest annually. However, keeping the same money locked in for 2 to 3 years could earn a higher return of 7% per annum.
The FD example illustrates the basic principle: if you invest your money for a short duration, you will generally earn lower returns, but if you commit to a longer timeframe, your interest rate tends to be higher.
Remember that a yield curve tracks the returns offered by Indian Government Bonds for various timeframes, not FD.
Now, what happens when short-term bonds offer higher returns than long-term bonds? This signifies a unique situation called yield curve inversion.What Does a Yield Curve Signify?
1. Normal Yield Curve: In a normal yield curve, the interest rates increase with the duration you lock your money for. This means that long-term bonds offer higher returns compared to short-term bonds. This scenario typically indicates a healthy and optimistic economy with expectations of future growth. In this case, investors demand higher interest rates for committing their money for longer periods.
2. Flattening Yield Curve: The yield curve starts to flatten when investors are uncertain about the future of the economy. When the curve flattens, it could mean that investors are getting more cautious and want to invest in both short-term and long-term bonds, causing the difference in interest rates to shrink. Investors watch for this because it might give clues about where the economy is heading.
3. Inverted Yield Curve: After flattening, the yield curve might invert or slope downward, which means that short-term bonds have higher yields than long-term bonds. An inverted yield curve is often seen as a warning sign for the economy. It frequently predicts an impending recession.
On March 30, 2022, financial markets witnessed that the yield on the 10-year treasury bond dipped below that of the two-year bond and the yield curve inverted. It is crucial to understand the implications of such an occurrence.
In the above case, the inversion was attributed to a mix of factors, including global economic uncertainty, trade tensions, and the Federal Reserve’s decisions.
After sensing the possibility of an economic downturn, investors shifted towards long-term bonds because they are considered safer investments during uncertain times. This increased demand for long-term bonds raised their prices and, as a result, lowered their yields.
Analysing Yield Curve Using Pairs of Bonds
When analysts analyse yield curves, they look at two pairs of bonds. Let’s understand this with an example. Imagine there are two types of bonds: one matures in two years and pays an annual yield of 2.5%, and another matures in 10 years and pays a yield of 3.5%.
Now, let’s see what happens when we compare these two bonds:
Yield Spread = 10-Year Bond Yield – Two-Year Bond Yield
Yield Spread = 3.5% – 2.5% = 1%
In this example, the yield spread is 1% and here is what that means:
Positive Spread: When the yield spread is positive, investors demand a higher yield for locking in their money for a more extended period (10 years) compared to a shorter duration (two years). This reflects confidence in future economic growth.
Negative Spread: If the two-year bond pays more interest than the 10-year bond, it would indicate an inverted yield curve. An inversion often hints at investor concerns about a potential economic downturn. In such scenarios, investors tend to favour longer-term investments for safety.
By analysing these spreads, you might get an early indication of a storm or an economic downturn. So, by keeping an eye on these yield spreads, investors can make smarter choices about where to put their money and how to prepare for what is coming in the economy.
In conclusion, the yield curve is a powerful tool for predicting economic shifts and understanding investor sentiments, serving as a guiding light in the world of investing. Understanding its dynamics empowers you to make informed decisions and adapt its strategies wisely, whether it slopes upward, signalling growth, or inverts to warn of potential challenges.