The Changing Slope of the Yield Curve - Assignment Example

The Changing Slope of the Yield Curve and Economic Prospects of an Economy xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Lecturer xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Task1: (5 marks) Plot and critically examine the shape of the yield curves that represent the structure of interest at 5 successive periods respectively for December 2009, December 2010, December, 2011, December2012 and December, 2013. The explanations should be drawn based on the expectation theory of the interest rates. Bond Year 2009 Chart 1.1: The above chart shows the movement in the Australian Government Bond yield curve and at such a time the previous year, the sever downward slope indicated the market was expecting the Reserve Bank to drop interest rates to lower than 3 per cent during this year. However, this did not happen. To the contrary, there was a rapid decline down to 3 per cent. This was maintained until the last few months. Bond Year 2010 Chart 1.2: Since August, interest rates have increased across the board on the back of stronger economic data, i.e. good employment, stronger China economy, and this has made the yield curve has rates above those at the end of May 2010. It will be interesting to see what will happen to interest rate in the near future considering the recent occurrence in the Euro-sovereign crisis issues that have started to affect the risk trade. The most likely result is that equities markets will be taking a break for a little while. There will then be movement back to cash and bonds which will witness the yield curve flatten significantly. Bond Year 2011 Chart 1.3: The Australian government bond yield curve flattened out significantly over the month of May. The curve is has been longer and lower for a long time in this year. This is an indication that investors had less confidence in the economic outlook in the country. The shorter term yields are however above what was seen in the month of March, which is probably due to the keen nature of the Reserve Bank regarding inflation and their own interest rates intentions. Bond Year 2012 Chart 1.4: As the above chart indicates, the yield curve had not moved much, most of which occurred at the longer maturity times. Bond Year 2013 Chart 1.5: This chart indicates very little change in Australian Government Bond yields over the last month. Given the situation in the United States, the situation in Australia appears to be out of place. There has been massive fund managers losing confidence in the United States Government and selling out of Treasury bonds. There has been a last minute consensus to prevent the United States from defaulting and sending the world’s financial markets into potential disarray. This situation did not happen but the uncertainty that it brought about cannot be under estimated since there could be a reoccurrence in the near future. This would lead to a greater change in government yields especially as they are a very good economic predictor, whether future inflation or the growth of economy of Australia. Chart 1.6: 2, 4, 5 Year Australian Government Bond Yields Task 2 (5 marks) The yield curve has been a good leading indicator of economic activities. Critically examine how the changes in the slope of the yield curve (long term treasury yield – short term treasury yield) provides possible explanation for changes in economic prospect of an economy. The yield curve was noticeably steep at around June 2009, which was an indication that a strong economic recovery was in the offing. The economic outlook however did not come out as expected leading to the decline of the longer term yields. There is still however a strong economic prospect, judging from the strong upward looking curve. The market also appeared to expect continuous rise in interest rates to be effected by the Reserve Bank. The market had a high expectation that there would come down, owing to a one year bond yield of about 4.25 per cent. There is however a chance of a 25 bps increase in March or April. This presents a very tough investment environment. Shares in such an environment are full of risks of all types from the prevailing Euro Sovereign crisis. The sluggish economy also makes investment in shares a very risky undertaking. The over dependence on China by the Australian government also left the economy in a very precarious position. Bond prices escalated (meaning low yields) with the property market remaining very fragile. The commodity, the risks and the gains having almost cancelled out, with limited expected return. There has been strong decline in equity since the highest point around April. This has been attributed to the uncertaintythat accompanied the Euro crisis which was thought to have been caused by Greece. Though the Euro effect is far put from Australia, there is always the flow-on effect, that is, a Greek, Irish, and/or Portuguese independent default results in a collapsed banking system in each country which is recorded onto the balance sheets of Euro banks which later went around the world. This brings about the potential for liquidity crisis in the worst scenario. This happened to be the situation with the U.S Treasury bond, probably due to the euro crisis experienced at that time. This means that the longer term economic outlook will be interesting for investors. Yields look low because inflation is expected to be low and the economy will be weak. Many investors may have been attracted by the over 20 per cent returns of the share market since mid-2012. There was however a sell off that saw the ASX200 index drop almost six per cent. Conclusion The bottom line is that the fact that the one year yield are above the cash rate for the first time in a while. It is believed that the mid 2011, just before the Euro crisis changed everything. With an upward sloping yield curve, all indications are that the cash rate may be stable to rising over the next twelve months. However, with the Australian dollar at a season low of ninety six US cents at the moment, RBA may have to struggle with doing nothing to the cash rate and especially, given their expectations are for continued below the trend economic growth due to the end of the Resources Investment Boom. On the other side, the lower economic growth is due to the fact that the current cash rate of 2.5 per cent has downside limits. Thus going lower without an economic crisis may unnecessarily use up much of RBA resources which may be of importance given the likelihood of a crisis emanating from the international front. In addition, there are extremely high housing costs in Perth, Melbourne and Sydney, which may further be fueled by low rates. The recent debate on the debt ceiling of the US will ensure QE3 remains steady. This will provide an opportunity to share markets to continue to be artificially boosted and the yield curve suggests that locally, there will be low interest rates, low inflation and therefore low economic growth for a long period of time. References 1. FUREYOUS. (2014). Australian Government Bond Yields. [Online] Available at: http://www.fureyous.com.au/2013/10/21/australian-government-bond-yields-little-change-in-a-month-but/ 2. U.S BEPARTMENT OF THE TREASURY. (2014). Resource Center. [Online] Available at: http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualization.aspx 3. FINANCIAL REVIEW. (2013). Beware the Steepening Yield Curve. [Online] Available at: http://www.afr.com/f/free/markets/market_wrap/beware_the_steepening_yield_curve_bb1RyCJDRiooUUCpyDSEwL Read More