What is a Yield Curve?
If only there were a way to accurately predict the future course of money rates & economy. Well, there is! Yield curves provide investors with an indication of the market’s expectation about future interest rates and the trajectory of the economy. Yield curves have also been reliable predictors of economic growth and recessions.
In this post, I’ll describe what yield curves are and how investors might use them.
Yield Curve Definition
A yield curve commonly describes the visual representation of interest rates over time. The “curve” refers to the shape of the line plotting the rates. An upwardly sloping yield curve generally indicates a market’s expectation of future prices moving higher (i.e. the future value of money being less valuable).
Apples to Apples
When the media talks about the “yield curve”, they are usually referring to benchmark government rates. But, investors could consider forward rate curves for most any quoted asset, liability, or financial instrument. The important thing is to compare future prices of fungible things. Like, GIC rates from the same issuer, mortgage rates from the same issuer or index, or the price of the same grade of oil at future points in time to be delivered in the same location.
Generally, yield curves for government bonds are “upwardly” sloping because the future value of money is expected to be worth less than the current value of money (i.e. inflation). So, it makes sense for investors to demand higher interest rates the longer they lend/borrow in time. But when markets expect prices to contract instead of expand (i.e. deflation), market participants may be willing to lend/borrow long at lower rates compared to short term rates.
The shape of the yield curve, whether its upwardly sloping or “inverted” gives investors an indication of the market’s expectations about the future.
The future value of money is one factor that determines the slope of yield curves. But, other factors such as expectations of credit risk or expectations about future economic conditions will also influence the shape of yield curves.
When a yield curve become “inverted”, it usually means that markets expect future prices to be lower than current prices.
Beware of Inverted Yield Curves
The bottom line for investors is that an inverted yield curve is a bearish signal. This is because an inverted yield curve confirms investor’s expectations about future economic conditions, interest rates, and their willingness to earn interest at current rates rather than lock their money away at lower rates.
Financial services business are also strongly impacted by the price of money. Banks generally bet on inflation by “borrowing short, and lending long”. This means that banks generally earn a spread (or net interest margin) between short term rates and long-term rates. Typically, this means collecting customer deposits held on demand, and lending that money for longer terms to other customers (in the form of mortgages and other loans to customers).
Yield Curves and Bank Stocks
If you are a blue-chip Canadian investor, you probably own shares of the big banks and insurance companies. The best time to hold shares in these companies might be when net interest margins are expected to grow the most, not when they are shrinking.
Therefore, when yield curves flatten, it makes it tougher for banks to earn profits.
For fixed income investors, like retirees and pension funds, the slope of the yield curve is at the centre of important strategic decisions. Generally, retirees can diversify away interest rate risk by laddering maturities of their fixed income investments. This means holding GICs & bonds of various matures such as 1 year, 2 year, 3 year, etc. Doing so will spread interest rate risk over time.
Today, many fixed income investors use index funds to manage this risk too. If you would like to learn more about the indicators that investors can use to determine their tactical asset allocation, please get in touch with us.