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What is a Yield Curve?
Many investors in the stock market have come to hear of the term ‘yield curve’. This term actually is used to denote the relationship between the cost of borrowing or the interest rate and the time or term of maturity of a certain debt instrument in a particular currency.
Traders in the different markets closely watches the US dollar interest rates paid on US Treasury securities in varying maturities by plotting them on a graph known as the yield curve. Any movements in rates and maturities of US Treasury securities as plotted by the yield curve will impact on stock markets worldwide.
Yield Curve and US Rates
The yield curve in terms of US government instruments like bonds and treasury notes is a way of evaluating short and long term investment trends and would necessarily reflect the country’s economic outlook.
This is why all traders in the different financial markets of the world closely monitors the varying interest rates and maturities on US government securities to determine the yield curve that would also serve as their basis in determining their own rates for short, medium and long term debt instruments.
Three Forms of Yield Curve
In actuality, there are three kinds of forms that a yield curve can take depending on the interplay of interest offered and the length of maturity.
An upward curve is normal and would indicate a higher yield for longer maturity while a downward curve is not normal and would mean higher yield for shorter maturing instruments. Downward curves or inverted curves are abnormal and would signify an economy nearing recession. A flat yield would signify there is no difference in interest between short and long term investments.
Yield Curve in Bonds
For investors in bonds it will serve them well if they examine carefully the kind of bonds they will be investing because notwithstanding the plotted yield, the risk attendant to the kind of bonds they will invest in will be entirely another factor to consider.
Plotted Yield Curve of Treasury Securities
Financial markets around the world usually relies in the US Federal Reserve for their regular publication containing plotted yield curve based on updated rates and terms of Treasury Securities. Global markets use these plotted yields as basis for measuring yield on other kinds of debt instruments.
Importance of Yield Curve to the Economy
By using the yield curve, investors, traders and economist alike can ascertain the financial standing or situation of the economy. When the upward curve is on a sloping line, it would mean that a higher rate is need by investors due to longer maturities. A steep upward slope means economy is bullish with a corresponding need for higher rates. A flat curve is indicative of uncertainty in the direction of the economy.
The Economy on an Inverted Yield Curve
The inverted yield curve was plotted just recently not elsewhere but in mainland USA. The financial credit crunch brought about by the Home Mortgage problem and exacerbated further by the skyrocketing cost of fuel brought about this inverted curve that suggested to everyone to expect a slowing down of economic growth and low inflation
The lowering of rates was forced on the Government to preclude recession from hitting the economy. The adjustment in the lowering of the interest rates by the Federal Reserve was made in response to the bleak economic forecast. It was done in several stages so as not to jolt the economy until it reached 50 points
Yield Curve Theories
There were several theories regarding the Yield Curve that sought to explain the nature of the curvature. These theories all related the yield curve to the desires of the investors in relation to interest rates and the maturity of their investments.