Question

There is a famous line from Shakespeare “Beware the Ides of March.” We are almost there. The topic currently is The Yield Curve. Please, for this posting go to https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield and get some data about the yield curve and use that data to answer this question. You can download a Word version of this document at the bottom of this page. The basic idea is to look at the data for the yield curve for March 1, 2018 and compare it with the yield curve for some reference date. You have these choices for a reference date: 1) your birthday (if you want to share), 2) a date that is important to your family (if you want to share), 3) a date at least 5 years ago but not more than 10 years ago (you have to tell the class what the date is), 4) your date cannot be within 2 weeks (plus or minus) of a date chosen by a previous poster. For this posting you are to do the following Describe the yield curve on March 1, 2018, it would be extra points if you make a graph of the yield curve and post it for part A. and B. Describe the yield curve on your reference date. Based on the yield curve on your reference date, what inferences can you draw about expected movements in interest rate based on their yield curve at that point it time. Fully explain these expectations. (Extra Bonus) What were the actual movements in interest rates after your reference date and how did the actual movements in interest rates compare with the expectations with the yield curve. If you don’t pursue the bonus of identifying actual movements in the interest rates following your expectations statement your classmates will be invited, as an IR statement, to compare your expectations with reality. This discussion posting is a “bit harder” than usual and I strongly suggest you read the text material about the yield curve carefully. Some interest rate analysis incorporate the yield curve into their expectations setting process for future interest rates. For most of this question there isn’t a “certainly right” answer.

Answer 1

Lets take our reference data as 28th Janauary 2011. Now we have 2 dates. Lets call 1st March 2018 'A' and 28th January 2011 as 'B'. First, let us draw the curves. I have done so below for both of them.

Curve for 1st March 2018-

Curve for 28th January 2011-

Now that we have the graphs, lets describe the yield curves on both dates.

The yield curve for both of the dates is sloping upwards. Such a yield curve is called 'normal yield curve'. What it means is that the longer you keep your money invested, the higher will be the interest rates you get. Why? Because when you keep your money invested for longer period, you expose it to more possible risks. While there might be little chance that a recession will hit within 6 months, there is a higher chance of one in 10 years or more. Maybe some other adverse calamity such as imposing of tariffs or market crash will occur. You are taking more risk when investing for longer period and hence you are rewarded with higher return on your investment. (There are two more types of yield curves- flat and inverted).

You will also notice that, while both are sloping upwards, curve A is comparatively flatter than curve B. What does that mean? A yield curve is often taken as a signal for upcoming economic activity. Analysts would often see the yield curve rate at short term (often 1 year) and long term (often 10 years) and see the difference between them. If there is a big difference, it usually means that the outlook for the economy is positive and an economic expansion is thought to be coming. If the difference isnt much, its taken as a sign of stangnancy in the economy. So what does this tell us about curve A and B. The difference between the 1 year return and 10 year return for curve A is .76%. The same for Curve B is 3.12%! Hence the curve B is steeper. It also tells us that the outlook for the economy was far more positive in January 2011 than its in March 2018.

Now we have to predict the interest rates movement after our reference dates, based on our understanding of the yield curve. The steeper curve and the high difference between 1 year yields and 10 year yields in 2011 tells us that economy was in expansion and outlook was positive. Usually after an expansion period, a period of low growth or even recession in rare case follows. As time moves, the yield also reflect that. The difference between 1year and 10year yields starts shrinking (the curve becomes flatter). From our 2011 reference rates curve, we predict that the rates would slowly become lower and the difference between 1 yr and 10yr yields would become lesser.

So was that the case. Indeed it was! The yield difference between 1 yr and 10yr yields came down to 1.81 in 2012, from 3.12 in 2011. Lets see how the yield curve looked like on 29th January 2012.

It is comparatively flatter than the curve in 2011.
In fact, it general trajectory of the yield difference has been continuously going down after 2011, barring one exception. We plot the yield differences by year below and the trend is clear.

In conclusion, it is fair to say that our prediction of yield curve movements were correct.