When the yield curve falls generally upwards
Term structure of interest rates Definition & example | - 2021 - Financial Dictionary
What is it:
The Interest structure of interest rates , also called The Yield Curve is a graph that plots the yields of bonds of similar quality in relation to their maturities from shortest to longest.
This is how it works (example):
The interest structure of the interest rates shows the various yields that are currently offered for bonds of different maturities. It allows investors to quickly compare the returns on short, medium and long term bonds.
Note that the chart does not show coupon rates for different maturities - this chart is called the spot curve.
The yield curve has three main shapes. When the short-term returns are lower than the long-term returns, the curve rises up and the curve is called the positive (or "normal") yield curve. Below is an example of a normal yield curve:
When short-term returns are higher than long-term returns, the curve falls down and the curve is known as the negative (or "inverted") yield curve. Below is an example of an inverted yield curve:
After all, there is a flat yield curve when there is little or no fluctuation between short-term and long-term returns. Below is an example of a flat yield curve:
It is important that only bonds with similar risk are drawn on the same yield curve. The most common type of yield curve records Treasury securities because they are considered risk-free and thus provide a benchmark for determining the yield of other debt securities.
The shape of the curve changes over time. Investors who can predict how the yield curve structure will change can invest accordingly and take advantage of the corresponding changes in bond prices.
The interest structure is calculated and published by the Wall Street Journal, the Federal Reserve and a number of other financial institutions
Why it matters:
If the yield curve of interest rates is generally positive, it suggests that investors are getting a higher rate of return for the increased risk of borrowing their money for an extended period of time.
Many economists also believe that a steep positive curve means that investors expect strong future economic growth with higher future inflation (and thus higher interest rates). and that a strongly inverted curve means that investors expect sluggish economic growth with lower future inflation (and therefore lower interest rates). A flat curve generally indicates that investors are uncertain about future economic growth and inflation.
There are three central theories trying to explain why yield curves are shaped the way they are.
1. The "expectation theory" says that the expectation of rising short-term interest rates creates a normal curve (and vice versa).
2. The "liquidity preference hypothesis" states that investors always prefer the higher liquidity of short-term debt securities and therefore any deviation from a normal curve will only prove to be a temporary phenomenon.
3. The "segmented market hypothesis" states that different investors adhere to certain maturity segments. This means that the yield curve reflects the prevailing investment policy.
Since the yield curve generally indicates future interest rates that indicate an expansion or contraction of an economy, yield curves, and changes in interest rates, these curves can provide a great deal of information. In the 1990s, University Professor Campbell Harvey found that the last five US recessions were preceded by inverse yield curves.
Changes in the yield curve can also affect portfolio returns by making some bonds relatively stronger or less valuable compared to other bonds. These concepts are part of what motivates analysts and investors to carefully study the yield curve.
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