The Slope of the Yield Curve - Report Example

Yield Curve Student’s Name Course/Number Institution Date Instructor Name Yield Curve Executive Summary Since the 1980s, world economists as well as a financial analyst have argued that the slope of the yield curve is an excellent predictor of future economic performance. Wide-ranging literature has indicated that the yield curve is a reliable predictor of economic recessions as well as future economic performance. According to Hagan and West (2006), there is a relation between the slope of the yield curve and the successive changes in consumption, investment, industrial production, and GDP. However, there is lack of a unitary agreed explanation detailing the link between depression and the slope of the yield curve. The lack of unitary explanations has led most economic scholars to inquire if the yield curve can be utilized to predict future economic performance. The other factor weakening the use of the yield curve is the absence of a standard mechanism to developing forecasts using the yield curve movements. More so, the present various ways to developing and interpreting the yield curve forecasts could result to misreading of the indicator in real time. Arguably, the use of the yield curve to forecast economic downturn has been largely empirical, documenting correlations instead of developing theories to clarify such correlations. In this report, the focus is on discussing how changes in yield curves impact on an economy. In discussing how the yield curve influences an economy, the focus is on examining the different types of yield curves that represent the structure of interest over a period from December 2009 to December 2011. The report examines the effectiveness of monetary policy responses in the wake of economic and financial stress and how those responses have affected the shape of the yield curve. It also focuses on providing workable conclusions and Policy implications for investors and policy makers. A Table of Contents pg Introduction 4 Types of yield curves 5 How changes in the yield curve slope impact future economic prospects 7 Australia and U.S yield curve comparisons 8 Effectiveness of monetary policy in economic and financial stress 10 Workable conclusions and policy implications 11 Reference List 13 Appendices 15 Introduction Most of the present and earlier literature argues that the slope of the yield curve is an important predictor of future economic performance. Arguably, the nature of the yield curve gives information of the economic expectations as well as interest rates. A normal yield curve is usually positively sloping. This implies that, as the duration to maturity rises, investors require increasing yield. In reality, long-term investments involves more risk due to the fact that uncertainties on economic situations become more as time is stretched further. Thus, investors require more yield in return to cover for the uncertainties. Without doubt, the slope of the yield curve gives the investors information regarding the future economic situations. A positive slope would give investors an indication that the future economy is growing and that inflation will increase. Several studies have argued that there is a close link between the slope of the yield curve and the expectations of economic performance. More so, several studies points that the slope of the yield curve have a direct relation with the successive changes in consumption, investment, industrial production, and GDP. Nevertheless, there is a lack of a unitary agreed explanation indicating the relation between depression and the slope of the yield curve. This inconsistency has led most economic scholars to inquire if the yield curve can be utilized to predict future economic performance. This report gives insight on how changes in yield curves impact on an economy, by examining the different types of yield curves that represent the structure of interest over a period from December 2009, to December 2011. It also gives insights into the effectiveness of monetary policy responses in the wake of economic and financial stress and how those responses have affected the shape of the yield curve. Finally, it focuses on providing workable conclusions and Policy implications for investors and policy makers. The different types of yield curves that represent the structure of interest over a period from December 2009 to December 2011 The Australian government bond yield curve experienced several forms over a period from 2009 to 2011. There are various types of yield curves and among them includes the normal yield curve, inverted yield curve, flat yield curve, and steep yield curve. The Australian yield curve has at one point experienced these kinds of yield curves. From the graph below, the instances of a normal curve can be seen as from October 2010 to December 2010 and several other instances. The normal yield curve normally indicates that the yield to investments increases as maturity time increases (Derry and Murphy, 2008). The slope of the normal yield curve is positive indicating that the future economy is expected to grow. According to Fisher and Felmingham (2009), the positive slope of the yield curve indicates investor anticipations for the economy to expand in the successive years as well as the rise in inflation. The anticipation of increase in inflation associated with expected economy expansion, leads to anticipation that the central bank could squeeze monetary policy, through increasing a short term interest in an effort to reduce inflationary pressure and slow expansion in the economy. In the case of the graph below, the positive slope of the yield curve was an indication that the future economy would expand and that inflation would rise. An inverted yield curve was experienced between June 2011and August 2011. There are other several instances where the Australian government bond yield curve was inverted. This include from April to June 2012. As argued by Cwik (2005), an inverted yield curve happens if the long-term interest rates are lower than the short-term interest rates. Cwik (2005) argues that the investors in such a case will prefer to invest in the short term investments especially if they view the economic performance will decline or slow down. An inverted yield curve is argued by most present and earlier literature as an indicator of worsening economic situations. According to Rudebusch and Wu (2008), the inverted yield curve has been used since 1970 to predict the economic situations. Accordingly, since 1970s, the inverted yield curve has been used seven times to predict worsening economic conditions and six out of those has been successful. More so, the New York Federal Reserve and other serious monetary systems regard it as a precious predicting technique in predicting depressions. Besides pointing an economic downturn, an inverted yield curve signals that inflation will remain low. The present inverted yield curve could be an indicator that economic performance could decline. Graph: showing the different types of yield curves over a period from December 2009 to December 2012 The other type of yield curve evident in the above curve is the steep yield curve. This is seen in the month of June 2009 and a bit of October 2011. This form of yield curve occurs after the end of an economic downturn, or at the start of an economic expansion. A flat yield curve occurs when the long-term interest rates are the same to the short term interest rates. The Australian government bold yield curve experienced a flat curve in a bit of March 2010. A flat yield curve points out to uncertainties in the economic future. The uncertainties in economic situations could revert to an inverted curve or a normal yield curve. How changes in the slope of the yield curve impact on future economic prospects The slope of the yield curve says a lot more concerning the future economic situations. According to Cohen (2006), the slope of the yield curve provides vital information and insight into the future economic outlook. The shape of the yield curve gives details of the market’s outlook for consumption, investment, as well as interest rates. A normal yield curve is usually positively sloping. This implies that, as the duration to maturity rises, investors require increasing yield. In reality, long-term investments involves more risk due to the fact that uncertainties on economic situations become more as time is stretched further. Thus, investors require more yield in return to cover for the uncertainties. Since the slope of the yield curve gives the investors information regarding the future economic situations, it impacts the economy because it influences on their investment decisions (IMF, 2012). A positive slope has a positive impact on the economy as it gives the investors an indication that the future economy is growing and that inflation will increase (Liz, 2009). Since investors need returns, they will invest on longer-term securities, which provide high yields. This is as opposed to a situation where the slope of the yield curve is negative (Finlay and Chambers, 2008). A negative slope indicates that a downturn in coming and discourages investment, in long-term securities, which impacts the economy. The changes in the slope of the yield curve influence the future of the economy in that it influences the investors’ decisions regarding investing on long-term or short term securities. A normal yield curve has a positive slope and indicates that the economy will expand (Spencer and Liu, 2010). This will give an indication to the investors to invest in longer-term securities, which yields high returns. A flat yield curve usually indicates uncertainty. This greatly influences the future economy in that investors will be reluctant to invest because of the uncertainty. They are not certain whether the yield curve will end up normally or being inverted. An inverted yield curve points out to investors that the future is downturn. No investor would want to risk by investing on long-term securities when they expect the economy to decline or collapse. Thus, the slope of a yield curve has a profound impact on the future economic prospects (Kroszner, 2006). Most present and past studies have argued that there is a close link between the slope of the yield curve and the expectations of economic performance. According to Hagan and West (2006), there is a direct influence brought about by the slope of the yield curve on the successive changes in consumption, investment, industrial production, and GDP. Australia and U.S yield curves comparisons The two selected developed countries are United States and Australia. The two nations are experiencing different types of yield curves with Australia experiencing a normal yield curve while U.S is experiencing a steep yield curve. The Australian normal yield curve indicates that the yield to investments increases as maturity time increases. The normal yield curve indicates that the future economy of Australia is expected to grow. It also implies that the country’s inflation will rise. At the current moment, the U.S. yield curve is climbing steeply as it can be evident from the graph below. This is after it had experienced various shapes in recent months. For most parts of April, the yield curve was flat. This occurred because the long-term interest rates were similar to short term interest rates. The U.S short term and long-term interest rates were almost similar at the moment. At the moment, the curve is steep implying that the economy is beginning to expand, and the investors' inflation worries forces them to sell their long-term investments reducing the prices of these investments forcing the yields of these investments higher. The steepening yield curve is reflects investors expectation that the economy will pick and thus, encourages them to invest more. The steep yield curve has a positive impact in that there is no worry in economic decline or collapse, not until the curve becomes normal. In this regard, the economy of Australia is expected to expand while that of United States is expected to expand rapidly. Graph: showing the current Australian yield curve Graph: showing the current Australian yield curve Effectiveness of monetary policy responses in the wake of economic and financial stress Monetary policy has an impact of influencing the shape of the yield curve as well as its slope. According to Waring (2012), there is no other bigger factor in driving changes in the yield curve part from the monetary policy. The monetary policy has a varying impact on affecting the short term interest rates as compared to influencing longer-term interest rates. The monetary policy has the effect of influencing the short term interest directly. The monetary policy influences the short term interest rates when it purchases and sells short term securities. It also influences the short term rates when it sends an indicator to the market that it intends to increase or reduce Fed funds rate. In some situations, a mere signal to the market of altering the short term rate has the effect of moving the yield curve. The monetary policy is effective in influencing the yield curve because it has a direct relationship with the short term interest rate. The Fed funds rate according to Estrella and Mishkin (2009) is the rate that banks borrow or lend to one another overnight. Accordingly, Estrella and Mishkin (2009) argue that since monetary policy is aiming at this rate directly, it is simple and direct to imply a close link between the short term interest rates and monetary policy. Despite the fact that the monetary policy does not have a direct influence on long-term interest rate, there exists a close link between the Feds Fund rate and these rates. In financial and economic stress, the monetary policy has reduced the short-term interest rate which has the effect of changing the lowering short term interest below the long-term rates. This has ha the effect of making the slope of the yield curve positive. A recent example where the monetary policy has been used to influence the yield curve is the pinning of the short term interest rates to zero by the U.S Fed. Another example regards the increasing of the Fed Funds rate in 1999 from 4.5 percent to 6.5 percent by the then Fed Chairman Alan Greenspan (Kroszner, 2007). The worries concerning inflation, as well as the additional returns required by investors for their compensation on investing into the uncertain future play a key role in long-term interest rates as compared to short term rates. This does not imply that monetary policy cannot e an effective tool in influencing the long-term interest rates. Inflation is a key issue that longer-term investors consider. Accordingly, the monetary policy can influence the inflation and thus, influencing long-term interest rates (Moneta, 2007). Through increasing or reducing the amount of money in the economy, they, monetary policy is not only influencing short term interest rates, but also influencing inflation anticipation in the market. This will go ahead to influence the rate the investors are prepared to accept on long-term securities. Where the investors view the monetary policy as aggressive on inflation, it is likely that the long-term rates will fall. On the other hand, if investors view the monetary policy as reluctant on inflation, it is likely that the long-term interest rates will increase. As a result of the increase in Fed Funds rate, the short term interest rates increased in early 2000. The long-term rates reduced and resulted in an inverted yield curve. Workable conclusions and policy implications The use of the monetary policy can be a highly effective tool when utilized at the right moment and at right selection of tools. The use of monetary policy has a direct influence on the short term interest rates which consequently will affect the yield curve. It is clear, however that monetary has an influence on long-term interest rate though not direct. By influencing inflation anticipation in the market, the monetary policy can influence long term-rate. In choosing to reduce the high rates of short term interest, the policy makers should be keen to ensure that the result desired is achieved without affecting other aspects of the economy. The policy makers should understand the extent at which the policy can be implemented to avoid worsening the economic situations or the results desired. Where there is high inflation in the economy, the monetary policy should respond by increasing interest rates. This will have an impact of reducing the money supply in the economy by making it expensive to acquire funds. Accordingly, it can reduce short term interest rates when there is deflation. This will make funds less costly and allow recovery in the economy. In review, changes in the slope of the yield curve have the effect of influencing the future economic prospects. A positive slope indicates an expanding economy while a negative slope indicates a possible downturn. Monetary policy has the effect of influencing the slope of the yield curve. It has a direct influence on short term interest rates and an indirect influence on long-term rates. In order to ensure effective results, the policy makers should select appropriate monetary policy tools to influence the yield curve. Reference list Australian Financial Markets Association, (AFMA) 2011, ‘2011 Australian Financial Markets Report’. Available at http://www.afma.com.au/data/afmr.html Barley, R 2012, What the yield curve is telling us. Wall Street Journal, New York. Cohen, R 2006, "A VaR-Based Model for the Yield Curve’, Wilmott Magazine, New York. Cwik, P 2005, "The Inverted Yield Curve and the Economic Downturn " New Perspectives on Political Economy, Volume 1, Number 1, 2005, pp. 1–37 Derry, J, & Murphy, M 2008, Estimating and Interpreting the Yield Curve, John Wiley & Sons, London. Estrella, A, & Mishkin, F 2009, ‘Predicting US recessions: Financial variables as leading indicators’, Review of Economics and Statistics, 80, pp. 45-61. Finlay, R, & Chambers, M 2008, ‘A Term Structure Decomposition of the Australian Yield Curve’, RBA Research Discussion Paper, No 2008-09. Fisher, C, & Felmingham, B 2009, ‘The Australian yield curve as a leading indicator of consumption growth’, Applied Financial Economics, 8, pp. 627-35. Hagan, P, & West, G 2006, "Interpolation Methods for Curve Construction". Applied Mathematical Finance 13 (2): 89–129. IMF 2012, Financial Markets Update, International Monetary Fund, Washington. Kroszner, R 2006, Why Are Yield Curves So Flat and Long Rates So Low Globally? Institute of International Bankers, New York. Kroszner, R 2007, Globalization and Capital Markets: Implications for Inflation and the Yield Curve, Center for Financial Stability, New York. Liz, R 2009, Rise in Rates Jolts Markets – Fed's Effort to Revive Economy Is Complicated by Fresh Jump in Borrowing Costs, Wall Street Journal. Moneta, F 2007, ‘Does the yield spread predict recessions in the Euro area?’, Working Paper No. 294, European Central Bank, Frankfurt. Rudebusch, G, & Wu, T 2008, ‘A Macro-Finance Model of the Term Structure, Monetary Policy and the Economy’, Economic Journal, 118(530), pp 906–926. Spencer, P, & Liu, Z 2010, ‘An Open-economy Macro-finance Model of International Interdependence: The OECD, US and the UK’, Journal of Banking & Finance, 34(3), pp 667–680. Waring, D 2012, ‘How the yield curve moves in response to the FED’, Journal of Banking & Finance. Zenios, M, & Ziemba, W 2006, Handbook of Asset and Liability Management, Volume 1, Melbourne, North-Holland. Appendices US Yield Curve Graphs US Yield Curve (1955-2012) More specifically the students will be required to complete the following tasks: Source: RBA, Delta Research & Advisory Table showing different yield rates for Australia from 1980 to 2010 Read More