Question

Describe the basic shapes of the yield curve over time.

Why does the yield curve shift?

Answer 1

Answer:

Majorly, there are three main types of yield curve and their shape depends on the relationship between the interest rates and maturity of the bonds:

1. Upward Sloping Curve (Normal): This is one of the most common yield curve and that's why referred to as normal curve. It indicates that a high duration bonds will attract higher interest rates as compared to low duration bonds. It works on the principle that if you are giving your money for a longer period of time then you are exposed to higher risk so you must earn higher interest on the same in contrast with the ones who have given their money for a shorter period of time. A longer period of time will be exposed to certain unexpected negative events and therefore, it attracts higher volatility.

2. Downward Sloping Curve (Inverted): It happens when the long term duration bonds offer less yields as compared to the short term duration bonds. Sometimes, the investors assumes that interest rates will decline in the long term future due to many reasons say decrease in inflation etc. and thus the yield curve becomes inverted i.e. downward sloping curve.

3. Flat Curve: It occurs when the all the bond durations carry similar yields i.e. maturity of the bond does not affect the yield. Although, its a rare situation, it happens when there is a transition between the normal and the inverted yield curve.

There are several factors that affect the yield curve and cause it to shift. For example, inflation is one of the most important factor affecting the yield curve. If there is a fall in inflation, interest rates are reduced which will cause an increase in the borrowings and people will have more money in their hands to to purchase goods and service and thereby increasing the purchasing power of the general public. In this situation, demand will increase but the supply will remain constant which will lead to increase in the price i.e. inflation causing the economy to be back to equilibrium. The complete opposite situation arises when there is a rise in inflation.
Economic growth is also one of the factors causing shifts in yield curve. High economic growth can cause increase in inflation due to increase in the demand of goods and services which will lead to increase in yields.