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The yield curve describes the relationship between short- and long-term interest rates (i.e., the "term structure"), and is often represented as a graph showing the duration of investment on the x-axis and the annualized interest rate on the y-axis. The yield curve is important because long-term interest rates are usually higher than short term interest rates, reflecting the fact that long term loans tie up money and make it inaccessible for longer periods of time. Many banks and financial institutions' profits are tied to the difference between short-term and long-term interest rates, as they make money on a "borrow short, lend long" strategy, rather than whether interest rates themselves are nominally low or high. In this strategy, banks borrow money from their depositors and pay these depositors short-term interest (such as in a checking account). Banks will then aggregate these deposits and lend them out in long-term loans (such as mortgages) that will not be paid back for many years, but which pay higher interest. Based upon the quantity theory of money, production growth is linked to monetary growth. Banks will presumably only create money for productive expansion by fractional lending predominantly when they are profiting from a normal yield curve, generally a proportional relationship between yields and times to maturity.
[edit] TheorySuppose an investor had a dollar he wanted to invest for ten years. One option would be to invest it in a 10-year bond that would pay some known interest rate for all ten years. Another option would be to put the money in a savings account; although today's interest rate is known, the investor could not be sure what return he would earn tomorrow, or any other day over the duration of the investment. For an investor to decide whether it was a better idea to invest in the bond or the savings account, he would need to:
The forces of supply and demand ensure that long-term interest rates adjust based on borrowers' and lenders' expectations of future interest rates, as well as their attitude towards interest rate risk (i.e., how much they value locking in a long-term interest rate today). [edit] PracticeIn general, the yield curve is "upward sloping"; that is, long-term interest rates are higher than short-term interest rates (a positive interest rate spread). When long-term interest rates become especially high relative to short-term rates, we speak of a steep yield curve, or a high interest rate spread. When long-term rates are especially low, we refer to a flat yield curve; at the extreme, short-term rates may be even higher than long-term rates, a situation referred to as the (often dreaded) inverted yield curve. Changes in the shape of the yield curve are important for equity investors for two main reasons: [edit] Macroeconomic indicatorInterest rates are important for the economy in many ways, and the shape of the yield curve depends critically on expectations of future interest rates. Many forecasters believe that an inverted yield curve (where short-term rates are higher than long-term rates) signals degrading future economic conditions. Inverted yield curves have a very high correlation with recessions or economic stagnation. In the enclosed chart, two inversions indeed led to extended bear markets. The result of the 2006-2007 yield curve inversion remains to be seen. The key difference between previous yield curve inversions and the most recent seems to be that 30-year treasury bonds that were discontinued in 2001 were restarted in 2006. The lack of new 30-year bonds may have led to a yield curve inversion that will not lead to a recession or bear market. At least, this seems to be the hope of some economists and investors.  Image:Yield Curve.pdf (Download a PDF version) [edit] Carry tradeMany financial services companies borrow money at short-term rates (for example, paying low savings-account interest rates to their depositors), and lend at long-term rates (for example, through mortgages). In a typical upwards-sloping yield curve environment, this can be a source of significant profit for banks, since they collect interest at high rates but only pay low short-term rates. As the yield curve flattens (or even inverts), this source of profit disappears. Thus financial service companies' profitability often suffers when the yield curve flattens. [edit] Going ForwardOf course, nothing ever stays the same in the market, and going forward, the yield curve will either steepen or become more inverted. Who is likely to win in each case? Countrywide Financial (CFC), Toll Brothers (TOL), and Washington Mutual (WM) are likely to incur losses if the curve flattens, since mortgage rates are typically tied to the yield on the 10-year Treasury. NVR Inc. (NVR) and KB Home (KBH) are also likely to decline, since higher mortgage rates will mean less demand for new home building. On the other hand, Goldman Sachs Group (GS), BlackRock (BLK), and Lehman Brothers (LEH), all of which own large institutional bond funds, will likely gain if the curve becomes further inverted. Meanwhile, eBay (EBAY), Google (GOOG), and Yahoo! (YHOO) are likely to benefit from a steepening curve, since a rise in long-term rates would mean that investor sentiment has improved, and that consumers are therefore more likely to show more discretionary spending. Apple (AAPL), Dell (DELL), and Microsoft (MSFT) would likely benefit as well. [edit] See Also |
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