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.