14 - The Yield Curve

The Yield Curve

• Speaker: S. Levkoff, PhD, CAP®

Introduction

• The yield curve is a critical tool in finance that captures the "health" of the bond market.

• Similar to stock market indices (e.g., S&P 500) for the stock market, the yield curve summarizes interest rates based on bond maturities.

• It reflects the term structure of interest rates, indicating how bond yields change with maturity.

• The yield curve can be used to predict financial market behaviors.

The Basics of the Yield Curve

• A graph representing annualized yield (rate of return) of government bonds versus maturity horizons.

• Government bonds are generally considered "risk-free" allowing for a comparison of equal risks.

• A "normal" yield curve slopes upward due to liquidity preference—investors prefer shorter maturities unless compensated with higher yields for longer durations.

Liquidity Preference Theory

• Definition: Individuals prefer more liquid assets over less liquid assets, controlling for factors like return rates and risks.

• Comparison example:

  • 30-year investment at 5% vs. 1-year investment at 5%.

  • Preference for the 1-year option due to faster investment return and flexibility.

• Implication: Investors lean towards shorter commitments to adjust strategies as market situations evolve.

Implications of Liquidity Preference

• Lengthy investment ties require higher compensation due to lost liquidity.

• A normal term structure suggests that long-term bonds should yield higher returns compared to short-term bonds to account for liquidity preference.

A Normal Term Structure

• A well-behaved yield curve shows increasing returns with increasing maturities.

• Higher annualized returns as maturity increases confirms liquidity preference.

An Atypical Term Structure

• Inverted Yield Curve: A sloping downward yield curve where short-term bonds yield more than long-term bonds.

• Raises the question of why investors would choose long-term bonds in this scenario.

Readjustment from an Atypical Term Structure

• Increased attractiveness of short-term bonds leads to higher demand (price goes up, yields go down).

• Result: Decrease in short-term interest rates.

When Prices Rise, Interest Rates Fall

• The relationship between bond prices and yields: Higher bond prices lead to lower yields.

• Yield calculation formula considerations when demand changes due to price fluctuations.

Implications of Flat or Inverted Yield Curves

• A flat or inverted yield curve is indicative of predicted drops in short-term interest rates.

• The extent of the inversion correlates with the sharpness of predicted interest rate declines.

Historical Predictions

• Inverted or flat yield curves predicted 7 of the last 10 NBER recessions in the U.S.

• Specific examples:

  • Preceding the dot-com bubble (2000).

  • Prior to the housing crisis (2007).

Relationship to the Stock Market

• Strong market performance leads to bond liquidation and stock investment, pushing stock prices up and bond yields down.

• Poor performance in the stock market leads to bond investment, driving bond prices up and yields down.

When Prices Fall, Interest Rates Rise

• Reflect on the correlation between bond pricing and yield to understand market dynamics.

Beliefs Matter: Self-Fulfilling Prophecies

• Beliefs Impact Actions: Anticipated future price changes can cause current market behavior to align with those beliefs.

• Increased demand can inflate current prices, validating the customer belief.

Demand Factors Influenced by Beliefs

• Buyers believing in higher future prices incentivize immediate purchases, shifting demand to the right.

• If sellers also anticipate price increases, they withhold supplies to maximize profits, further driving prices up.

Supply Factors Influenced by Beliefs

• Conversely, expectations of declining future prices reduce current demand as buyers wait.

• Sellers aiming to profit from current prices increase supply, leading to downward price shifts.

Conclusion

• Market dynamics are heavily influenced by investor beliefs and behaviors, evident in both liquidity preferences and self-fulfilling prophecies.