101 Concepts for the Level I Exam

Essential Concept 97: Yield Curves

The following figure show the UK government bond yield rates for July 2007, December 2010, and December 2011.

From the yield curve, it is evident that the UK short-term interest rates were higher in 2007 than the long-term interest rates. There was a significant change (decline) in interest rates between July 2007 and December 2010.

Yield curves have three characteristics:

Level: views of future inflation determine the level.
Slope: the magnitude of the risk premium determines the slope. The slope increases during recession.
Curvature

Most of the yield curve movement can be explained by changes in level followed by slope followed by curvature.

The shape of the yield curve is determined by:

Expectations of real short-term interest rates: views of future economic activity drive short-term rates.
Inflation expectations: if investors expect inflation and interest rates to be higher in the future, it results in an upward sloping yield curve.
Risk premiums: for bonds with longer maturity, the uncertainty in future inflation is higher which requires a higher risk premium.
Other factors such as regulations requiring banks to hold more short-term T-bills, or pension funds to hold long-term bonds.

The term spread and the business cycle

A yield curve is downward sloping when investors expect inflation and future interest rates to decline. An inverted yield curve is a sign of recession.

When the economy is in a recession and interest rates are low, the yield curve will be upward sloping. A booming economy has high inflation and future short-term interest rates.