Question

3) What factors influence the shape of the yield curve? Can I use those factors to aid my investing?

Answer 1

Host of factors influence the shape of the yield curve—monetary policy, inflation expectations, investor preferences, and macroeconomic influences from around the world.

As per Expectation Hypothesis:

If the shape of the yield curve is determined only by expectations – this is called ‘expectations hypothesis’ – forward rates calculated from the yield curve will correspond to the actually expected future yields. In this case, for instance, the forward rates calculated from government bond and interbank yield curves would directly indicate the future trajectory of the central bank base rate as expected by market participants.

Yield expectations can be affected by a variety of factors.

Short term yields are predominantly driven by the interest rate policy adopted by the central bank. Therefore, the relevant expectations are formed based on expected future trends in macroeconomic variables considered by the central bank (expected future inflation, expected changes in real economic variables) and the measures taken in response (central bank reaction function). For emerging currencies, exchange rate risk may be another important determinant of short-term yields, along with the sovereign default risk, which is factored into the prices of instruments denominated in the given country’s currency.

As per Term Premium:

Besides future yield expectations, the shape of the yield curve may also be affected by a number of other factors, collectively referred to as the term premium. Where there is a term premium, forward rates do not match market expectations concerning the future central bank base rate. Accordingly, the term premium is affected by uncertainties relating to future trends in macroeconomic factors (such as inflation and real economic activity), uncertainties relating to the monetary policy reaction function and uncertainties relating to exchange rate and sovereign default risks. Another important driver of the term premium is the asymmetric impact of deviations from the expected value in terms of the utility of market participants. In the case of interest rate swaps, for example, if it were not for this asymmetry, there would be no term premium stemming from the uncertainty of yields. In interest rate swaps – where participants take up symmetrical interest rate positions – short and long counterparties, respectively, would require equal compensation on account of upside and downside risks associated with the yields. the term premium may also be a product of two other factors in addition to the uncertainties of yield expectations. One such factor is liquidity risk. Investors require liquidity premia on their long-term investments (liquidity preference theory), because they may happen to need cash during the maturity period and quickly selling their longer-term investments is bound to entail certain expenses. The term premium may also be affected by structural factors of supply and demand. If arbitrage is not or is only partly functioning across different maturities (for example because market participants have a preferred investment horizon from which they only depart under a strong price stimulus – preferred habitat theory), market supply and demand in the longer maturity segments may deflect yields from the expectations.

Those factors can be used to aid one’s investing decisions:

1.Investors who risk their money for longer periods expect higher yields-

When the market expects the economy to function at normal rate of growth, there are no significant changes in inflation or available capital. The yield curve is normal.

2. Long term investors want to take the opportunity to lock in interest rates before they fall even further:

The market expects the economy to slow down and interest rates to drop in the future. The yield curve is inverted.

3. Long-term bond holders expect the economy to improve quickly in the future:

Long-term investors fear being locked into low interest rates so therefore demand greater compensation more quickly than the more liquid short-term rate holders. The yield curve is steep.

4. The market is at the point of inflection, preceding either a recession or an economic pick-up:

The yield curve is flat.