A yield curve is a chart that plots the relationship between maturity and yield for bonds of equal face value and creditworthiness but different maturity dates.
Yield Curves in Financial Theory
Generally bonds of otherwise equal face value and creditworthiness with later maturity dates will require a higher yield to compensate for the greater uncertainty involved with longer time periods.
Therefore, most yield curves tend to slope upward at a decreasing rate, as it plots the increasingly higher yields demanded by investors for later and later maturity dates with the rate of the increase tending to slow over time.
However, upward sloping yield curves are not always the case. Changes to expectations can make longer dated bonds lose value, while shorter term bonds may mature before the expected changes are to take place or their impact is to be felt.
For example, if a central bank is expected to raise its rates in 2 years, then current bonds that will mature before this event will still offer a comparatively high interest rate, while current bonds that mature after the event will not.
A yield curve where longer dated bonds have a lower yield than nearer dated bonds is known as an ‘inverted yield curve’.
Yield Curves and Economic Activity
The most famous and widely used yield curves are those that track the yields for government-issued bonds.
These yield curves are important because of the sheer volume of value that they represent and the fact that they are the benchmark for other interest rates. Therefore, these yield curves can be used as a bellwether for the prospects of the national economy.
When a yield curve is sloping upward it means that people are expecting interest rates to rise in the future as a result of strong economic activity, so investors are demanding a premium for locking their money in for longer periods at current rates.
By contrast, an inverted yield curve indicates that investors expect interest rates to fall in the future, and are willing to pay a premium to lock in higher interest rates now for a longer period.
Therefore, the yield curve for government bonds is often a strong indicator of current market sentiment toward national economic prospects.
Yield Curves and Trading
Day traders can use yield curves to get a broad picture of current economic prospects or to analyze the prospects of a specific institution.
The yield curve represents one of the best tools for day traders to evaluate national economic prospects, as it demonstrates market perception through actual investment decisions, as opposed to merely reported sentiments.
However, day traders should keep in mind that the value of government debt can change rapidly, and the yield curve for government debt is far from a foolproof predictor of national economic prospects.
The yield curves for private bonds are also useful tools for evaluating the prospects for individual institutions. An institution should also generally have an upward sloping yield curve for its debt, and a flat or inverted yield curve may signal significant trading opportunities in an institution’s debt or equity.
The intuitive simplicity of yield curves makes them highly useful tools for quickly evaluating the prospects of an institution or country. However, a yield curve is only useful for a cursory analysis, and any real trading decisions should be based on more in-depth analysis.