The Most Important Curve in Finance
A brief introduction to the yield curve and its economic significance
One of humanity’s great discoveries is the fact that the future can be transacted with.Lending is about as old as the civilization itself. Around 3000 BC in ancient Mesopotamia, farmers were with the promise of paying back with crops after harvest. This practice helped allocate resources to their productive purposes — those with extra seeds but no land could invest, while those with land but not enough seeds could utilize it more effectively. The farmers discovered that not only is it possible to transact with the future — it can benefit both individuals and societies.
Time Is Money
Interest rate is the exchange rate between present and future money.
Today’s economy — not unlike the society itself — is built on promises. Stocks, bonds, consumer loans, and mortgages all derive value from promises of future rewards. How much is the future worth compared to the present? What is the value of time? That’s a deep question. Fortunately, there is a surprisingly good proxy for that — interest rates. Interest rates can be thought of as the (annualized) price of today’s money, expressed in future money’s terms. This allows us to recast our question and ask more specifically: what is the appropriate interest rate on a hypothetical loan that is expected to be repaid at a specified future time (that is, at its maturity)? How does the appropriate interest rate depend on the maturity (of some hypothetical loan)— or, put more succinctly, what is the term structure of interest rates? That’s precisely the information encoded in the yield curve.
Unlike in Mesopotamia, when the interest rate was limited to 33% by the , interest rates — long-term interest rates in particular — today are determined by financial market participants. Market participants have a strong incentive to estimate the correct interest rate to price a future payment. But what is the “correct” rate and how does the market determine it? And what does maturity have to do with it?
No Two Interest Rates Are Created Equal
Let’s assume you’re asked to lend money. What’s the first thing you ask? “How much do you need?” and “When will I get it back?”. Let’s focus on why the latter is important.- First, you want to know whether you are going to get your money back. You would be taking on some credit risk that you would want to be compensated for.
- Second, you’d think about the things you could do with that money in the period if you don’t lend it. Sure, you can spend it, but you may also deposit the money in the bank (or invest it in the financial markets) if it’s offering — or you expect that it will do so in the future — a more attractive rate of return. If you lend the money longer-term, you want to be compensated for locking up your liquidity, making you unable to react to better opportunities now, but also those that may arise in the future (i.e., one that offers a better return on investment). A practical way of formalizing this is to say that you’d need to factor in your interest rate expectations.
Now, the appropriate level of compensation for each of these factors will depend on the key piece of information: the maturity of the loan, i.e. when you should expect to be repaid. Since different repayment periods may imply different expectations relating to these two components, the demanded interest rate will correspondingly be different. For example, if you anticipate a rise in short-term interest rates (e.g., bank deposit rates), and the offered long-term rates do not compensate for the expected increase, you may decide to keep your money at the bank instead of lending it for a longer term.
The yield curve represents the interest rate as a function of time to maturity.
These varying expectations associated with different future points in time give rise to the yield curve, which can be defined as a representation of the relationship between interest rates and time to maturity. That definition may come off as a bit too general; to which underlying loan does the curve-implied interest rate apply? Who is providing it, and to which borrower? That’s up to us to decide — yield curves can be derived for any borrower (if there is sufficient data). Nevertheless, economists are often interested in government bond yield curves, as government bonds are among the most abundant and liquid debt instruments. They also reflect the financing costs of the largest (and usually the most creditworthy) borrower in the country.
Yield Curves and the Business Cycle
Yield curves are so important because interest rates are so important.
Interest rates make their way into virtually all financial decisions. While the level of interest rates is indeed important, the yield curve provides an extra bit of information about how interest rates at different maturities relate to each other. This is often reflected in the shape of the yield curve. The most common way to characterize the shape of the yield curve is by its slope.
In times of economic growth, yield curves are typically upward-sloping, meaning that longer-dated instruments yield a higher rate of interest relative to those maturing earlier (). That’s because, even in times when interest rates are expected not to change substantially, investors need to be compensated for the possibility of a missed opportunity to capitalize on higher interest rates. The longer this period, the higher the demanded compensation; hence the upward-sloping shape. That’s called .
A rare but significant occurrence is the yield curve inversion, which is marked by short-term yields exceeding yields on long-dated instruments. Usually, the yield curve is described as inverted if the difference between the 10-year and the 3-month yield becomes negative. That’s usually a bad sign. It is often described as the harbinger of bad times — (although its predictive power has been recently).
- The cause argument. As the yield curve inverts and short-term yields increase past long-term yields, investor sentiment shifts toward short-term investments. This typically leads to an all-out increase in yields across all maturities, which hurts stocks — particularly those whose value lies in cash flows in the distant future (think growth stocks). A falling stock market is generally not beneficial for consumer and investor confidence. Moreover, banks tight their lending conditions as the economic gloom looms, and the pressure on their margins mounts as the cost of short-term financing rises (the banks need to pay higher deposit rates to their customers; however, ).
- The consequence argument. The central bank typically raises short-term interest rates when the economy is . This is usually accompanied by inflation as businesses struggle to keep up with demand. Higher short-term interest rates are precisely here to cool the economy, as they have a dampening effect on consumption, investment, and, therefore, output. Markets, of course, are perfectly aware of this and expect the economy to slow and, consequently, interest rates to be brought down. The expected fall in interest rates materializes as the inverted yield curve.
