THE YIELD CURVE AND THE ECONOMIC INDICATION - Essay Example

?THE YIELD CURVE AND THE ECONOMIC INDICATION. Table of content Executive summary------------------------------------------------------------------------2 Section A Introduction ----------------------------------------------------------------------------------2 Yield curve------------------------------------------------------------------------------------3 Types of yield curves----------------------------------------------------------------------3 The economic trends of U.S.A and Australia reflecting the yield curve-5 Section A The effect s of the yield curve to the economy and its predictions-----5 Conclusion ---------------------------------------------------------------------------------7 References ----------------------------------------------------------------------------------8 Executive summary There is need to understand the economic tantrums that are witness in the world. The essence to understand these changes and as such predict them necessitates the use of the yield curve. This paper examines the yield curve and point out the influence in the prediction of the economy. The paper goes ahead to examine the yield curve of the USA and the Australia. This paper is divided into two sections. Section a answers the task one and section be answers task two. Section A Introduction The economic analysis in the international world has been witnessing many fluctuations and changes over the years. To access and analyze and even predict these economic fluctuations and changes, economics have been put to task on coming up with the techniques of making economic predictions. Interest rates are factored in as one of the indicators of economic changes globally. They can therefore be for a short term and for long term as well. These interest rates changes give a good prediction on future market trend for instance a three year borrowing of a company which will be influenced by the central bank rates of borrowing and therefore being necessary to analyze the interest rates to see their input into the economy whether positively or negatively. These interest rates basically have a very significant effect on any company or industry economically. The interest rates are never constant and these changes fluctuate from the short term interest rates to the long term interest rates. These changes are well explained in the yield curve. The yield curve is the best indicator of economic activities and it is therefore necessary to have better understanding of this for the benefit of explaining the economic trend. In this paper therefore I will give a critical look at the Yield curve and as well the different types of yield curves and their effect on the economy globally. Yield curve The simplest way to define interest rate is that it is the amount charged on the money borrowed. This comes in form of rates and the maturity amount. The rate is the timely amount given before the actual payment as per the agreement of the borrower and the bank. The maturity amount is the total amount paid after the period given for the repayment of the loan elapses. The yield curve is the representation of the interest that is representation of the long term and short term interest rates. It’s used to refer to the maturity of borrowings in the banking sector. This curve is plotted by using the interest rates and the maturity period. This curve provides a very crucial basis for the governments to evaluate their economies. It is very basic for the determination of the current and future economic status of a particular economy. It is used for the determining of many financial derivatives like lending rate and mortgages for borrowers. The analysis of the economy of a country will requires the inclusion of the yield curve so as to make it all conclusive. Types of yield curves There are various types of yield curve and it is worth looking at each of these 1. Upward sloping yield curve, This type of a curve is mostly used to show the inflation in the economy. It shows that there is a probability of inflation rising over the following years. It can also show that the yield is bound to rise or in other case that there would be growth in the economy. This curve in most cases is affected by the short interest rates. When the rates are low then the curve will take the upward slope Downward sloping yield curve This type at most cases will show that there is depreciation in the economy or in the yield. These are as a result of having the long term interest rates being high. This type of yield curve was most significant in America in the year 2010. The following year showed an economic depression in this country. Flat yield curve This type shows a transition period, it can mean that the yield are bound to move up or might be there is inflation. It can also reflect that there might be depreciation. In other cases it might show that that the current conditions are bound to remain the same. That is the either inflation, yield or the growth of the economy. These type of a curve was very popular in Australia in the 2009. The hampered yield curve In these case then the market always expects to have a drastic change or a period of unpredictable conditions or in other word fluctuations in the market and the economy as such. In most instances the economy might experience a drastic reverse of the rates. The economic trends of U.S.A and Australia reflecting the yield curve Between the year 2009 and the year 2011 the U.S economy recorded an interest rate of between 0.16 and 0.06. The rate starts high at the high 0.16 percent in the year 2011 and keeps on going down to the lowest value. A plot of the interest rates in each particular year against the investor and market expectation reveals rising yield curve. The study of this report reveals that, the interest rates in the short term were high while those of the long term were low. In these years it is evident that the U.S economy experienced a reception. This is as per the expectation that at a time when the slope shows such a slope then this scenario can be expected (U.S. ECONOMIC STATISTICS - MONTHLY DATA) From the study of the Australian interest rates as that of America. A similar trend is witnessed. In the years that experience a resection for instance 2001 the previous year’s yield curve plotted shows that there is an upward slope (aba website). Section two The effects of the slope curve to the economy and its predictions The yield curve is a very good indicator of inflation. In this case the long term rates are always depended on the investors. If the long term rates increase then it an expectation of the investor that the short time rates are going to increase in the future times is a fact that leads to investor having to hold on their investments. This state increase speculation in the economy a situation that causes inflation since prices of commodities will tend to rise while the investment is low. It has been researched by a number of researchers that there is a very considerable relationship between the yield curve and inflation (schich2002). The short term interest especially the three months rates if they lead to the upward curve then there is an expectation of a inflation as it was witnessed in that U.K in the year 2002. Before that year the slope was having an upward trend and this was because the investment was low, a situation that had been as a result of the short term interest being high. The yield curve can be instrumental in the assessment of the returns upon the maturity. This is possible in the sense that the value of investment can be accessed over a relative period of maturity. The curve can be used to reflect the points at which the curve shows high returns. These information can be used to estimate at which time the banks would expect high returns and thus have low rates of interest or lower their rates of interests(Ogden, Joseph,). This curve can also be very important in showing the yield levels of future times. The yield curve as we have seen assumes a particular shape depending on the expectation that the market brings forth. These can be very important in the determination of market directions. The shape can determine the levels of yield that can be expected at a particular period of time The use of the curve is very critical to governments and banks because at the end of the day it can be used to determine the interest rates and not only that but it is very critical in foreseeing inflation. One other thing is that it can be used to set the yield for all debts (Smets, Frank, 50). Conclusion The application of the yield curve is very necessary in the assessment of economic activities of a particular country. Governments have to be very critical in the use of the yield curve because it is a very basic tool in prediction of economic situation. These can help the governments to prepare adequately especially for hard economic times like inflation and recession. The analysis of the slope curve has clearly shown that its prediction are real, and thus there use cannot be overlooked by and government as such. References http://www.treasury.gov Mark Taylor, 1998. “The Slope of the Yield Curve and Real Economic Activity: Tracing the Transmission Mechanism,” Economics Letters, 59(3), 353- Ogden, Joseph, 1987. “An Analysis of Yield Curve Notes,” Journal of Finance, 42(1), 99-110. Paul Francis c. (2010). An investigation into the inverted yield curve and economic downturns Smets, Frank, and Kostas Tsatsaronis, 1997. “Why Does the Yield Curve Predict Economic Activity? Dissecting the Evidence for Germany and the United States,” Bank for International Settlements, Basle, and Working Paper no. 49. www.rba.gov.au/publications/rdp/2008 Read More