Yield
Curves and Term Structure
Financial markets in general and
banks in particular like to look at yield curves, which are basically a graph
of the nominal interest rate or yield of a given type of bond on the vertical
verses the time until maturity on the horizontal. The yield curve that gets the most attention is that for US
federal government securities. The
yield curve as given provides strong implications for expected foreign exchange
rates but we will leave that for a class in international finance.
Cool trick: “Riding the Yield Curve”. Borrow short at low rates, lend long at high
rates. This is one way that a lot of
banks and funds make profits. But there
is considerable liquidity and interest rate risk since short-term willingness
of borrowers to lend at low rates is uncertain.
Three "stylized facts"
describe yield curve behavior.
1) The are usually upward sloping.
2) Short and long interest rates tend to rise
or fall together (as is often true for rates across bond types, such as government,
commercial, municipal, foreign, etc.).
3) The yield curve generally has a downward
slope before recessions. It is rare
that a recession starts without the yield curve inverting but it is less rare
that the yield curve inverts but no recession follows.
For dates of
recessions: http://www.nber.org/cycles/
Inversion
~April 2000-Dec 2000, Recession began March 2001
Inversion ~ January 1989-Sept. 1989, Recession began
July 1990
Inversion ~
Jan 1982-April 1982, Recession continued until November 1982
Inversion ~
Sept 1980-Oct. 1981, Recession began July 1981
Inversion ~
Sept 1978-April 1980, Recession January 1980
There are three basic stories or
theories that are used to explain the yield curve.
1) Pure Expectations Theory. The long-term interest rate is just the
average of the short-term interest rates which would prevail over the ensuing
period. By arbitrage, people would
refuse to hold a long-term bond or an equivalent string of short term ones if
the interest rates were lower than that given by the other strategy. This theory has a hard time explaining
stylized fact number one.
2) The Segmented Markets Theory. In its simplest form, the markets for
differing maturities are basically unconnected so different interest rates can
prevail. Since bonds of differing
maturities have differing risks to the effect on the present value of the bond
due to interest rate changes, people will demand a higher interest rate on
long-term bonds to compensate for the higher risk. This theory has a hard time explaining stylized fact number two.
3) The Preferred Habitat Theory. This is a refinement of the Pure
Expectations Theory with an adjustment made for the increased riskiness of
longer maturities. In this case, the
interest rate on a long-term bond would be the average short-term interest rate
plus some "term premium."
Suppose the term premium was 0.1% per year and short-term interest rates
were expected to stay at 5%. Then the
rate one year out might be 5.1%, two years out would be 5.2%, and three years
out might be 5.3%.
Why do yield curves often invert or
become downward sloping before recessions?
* One,
recessions often lower inflation and thus lower long-term nominal interest
rates.
* Two, when an
economy falls into a recession, the Fed often lowers interest rates (the Fed
has the most control over short term rates) to try to stimulate the economy so
in the future short term interest rates will fall so long term rates should
fall be the reasoning of the Expectations Theory of Term Structure.
* Three, it is
believed that many recessions were caused by overly high short term rates
(1981, 1990, 2000 6.36% 3mo in Nov. 2000, 1.21 in Dec. 2002.) so the inverted
yield curve could be a reaction to remarkably high short term rates which
temporarily exceed the long term rates.
Comments, typos, questions? mwitte@northwestern.edu