A yield curve is a line that plots yields (interest rates) of bonds with equal credit quality but differing maturity dates. The slope of the yield curve can indicate future interest rate changes and economic activity. The Treasury yield curve is often referred to as a proxy for investor sentiment on the direction of the economy. The three key types of yield curves are normal, inverted, and flat. An upward-sloping curve (also known as a normal yield curve) is one where long-term bonds have higher yields than short-term ones. While normal curves point to economic expansion, downward-sloping (inverted) curves signal economic recession. Yield curve rates are published on the Treasury’s website each trading day.
Significance of short-term yields
In the U.S., the Federal Open Market Committee (FOMC) sets the federal funds rate, the benchmark for all short-term interest rates. The FOMC periodically raises or lowers this rate to encourage or discourage borrowing in the economy.
The FOMC’s mandate is to promote economic growth through low interest rates while containing inflation. Borrowing activity has an overall effect on the economy. If the FOMC wants to increase spending in the economy, it might lower interest rates, going forward. However, it is also concerned about inflation. If short-term interest rates are subdued for a long time, the economy may face inflationary pressure.
Decadal movement of short-term yields in the U.S. and EU
Market forces and long-term yields
If the bond market senses too low a federal funds rate, expectations of future inflation will rise. Long-term yields will rise to compensate for the perceived loss of investors’ purchasing power.
On the other hand, if the market believes that the Federal Funds Rate (FFE) is too high, the opposite can happen. Long-term yields decrease because the market believes interest rates will go down in future.
U.S. 10-year yield movements over the year
Types of yield curves
The normal yield curve
This type of yield curve is generally observed when bond investors expect the economy to grow at a normal pace, without significant changes in the inflation rate or any major interruptions in available credit.
Source: Google Image
The steep curve
This type of yield curve is generally found at the beginning of a period of economic expansion. It is found when short-term interest rates are depressed due to economic stagnation. Generally, it is triggered by a lowering of rates by the Fed as a way to stimulate the economy.
The inverted curve
This yield curve is generally found when long-term investors believe the current rates will fall. As one might expect, lower interest rates generally mean slower economic growth, and thus an inverted yield curve is often taken as a sign that the economy may soon reach a point of stagnation.
Source: Google Image
The flat curve
In the case of a flat curve, bond yields are similar across all maturities. A few intermediate maturities (six months to two years) may have slightly higher yields. However, the difference will be lower in yield to maturity among shorter- and longer-term bonds.
This situation arises because of an uncertain economic situation. It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown. It might also appear at times when the central bank is expected to increase interest rates.
As the economic situation is uncertain, investors demand similar yields across maturities.
Source: Google Image
Does the yield curve predict recession?
Yield curve predictions about future growth are of two general kinds. One attempts to predict the rate of growth that may be expected at some future point while the other tries to indicate the probability of a recession.
In general, the steeper the curve, the higher the expected growth. This observation holds true over time as well as countries.
Meanwhile, when an economy is slowing and inflation expectations are on the decline, yields on longer-term maturities such as 10-year and 30-year bonds typically fall toward the short-term maturities.
This flattening of the yield curve has acted as a recessionary signal if the curve becomes inverted. An inversion of the yield curve has predicted every U.S. recession in the last 50 years.
Source: Financial Times
Expectations from the FOMC meeting
In the November FOMC meeting, we saw the Fed call time on its $120B/month bond-buying quantitative easing (QE) program. The Fed announced that asset purchases would be reduced by $15B in November and by another further $15B in December. But with increasing inflation, consensus expects that the Fed, this time, might announce acceleration in tapering, with a $30B reduction slated for January and February. Also, the Fed could wrap up the QE program by March/April, leaving it with $8.8Tn of assets on its balance sheet. This would be more than double its pre-pandemic asset level. A faster tapering would also set the stage for earlier rate increases. Two rate hikes are expected in 2022. The market will be closely following the Fed’s updated economic projections and the latest version of the dot plot, which maps the policymaker’s rate expectations.
Several other central banks are meeting this week. On Thursday, the European Central Bank is expected to signal an end to its additional pandemic-inspired $2.1Tn asset purchase program.
RBI holds GDP growth intact at 9.5% for FY22
The RBI has retained its forecast of 9.5% GDP growth for FY22, which includes 6.6% growth in Q3 and 6% growth in Q4 FY22. Real GDP growth is projected at 17.2% in Q1 FY23 and 7.8% in Q2 FY23. All components of GDP registered y/y growth in Q2. This indicates improving consumption demand and a pick-up in pent-up demand.
With the increase in global commodity prices, RBI holds India’s CPI inflation at 5.3% for FY22. However, supply disruptions, a rise in crude oil prices, and the uncertainty around the Omicron variant can hamper RBI’s growth outlook.
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