Yield curves

The budget handed down by Treasurer Peter Costello delivered cuts worth an estimated $31.5 billion. While we all love tax cuts we don't want these much-loved tax cuts to increase inflationary pressures and therefore interest rates. In this 'Knowledge Bank' we will be looking at the 'yield curve' and how they can show the markets expectation of economic activity, inflation and interest rates.

What is the Yield Curve?

The yield curve is a graphical presentation that plots interest rates against time. That is, it shows the relationship between interest rates at different points in time. For instance, 3 months as compared to 2, 5, 10 and 30 year rates. As we all know, interest rates represent the cost of borrowing. The relationship of the interest rate figures compared to the the different timespans to maturity indicate the market expectation of the direction of future interest rate movements. We will be looking at four of the basic yield curves types. The normal yield curve, the steep yield curve and the inverted yield curve.

Normal Yield Curve

This is the most common yield curve. The theoretical reasoning behind this is that short-term interest rates are lower than longer-term interest rates because the longer time to maturity that you tie up your cash for, the greater the risk. It stands to reason that this "risk" factor commands a greater return. This type of yield curve signifies that the economy is increasing at a fundamentally sound rate and therefore inflationary pressures are low. This curve signifies that everything is travelling along fine.

The Steep Yield Curve

This particular curve usually appears after a recession. The reason for this is that during recession central banks will theoretically decrease interest rates to stimulate economic activity and hence growth. Therefore the difference between the lower than normal short-term rates and the longer-term rates will be larger than usual. The higher rates for longer term signify that the expectation for economic expansion has increased and longer-term investors require a higher return from their investments.

Inverted Curve

This type of curve exist when long-term rates are lower than short-term rates. The reason for this is that investors believe that the economy will get worse or that there will be an economic recession. For this curve to occur, inflationary expectations must be low because only then will the lower long-term rates be justified with lower returns.

Many analysts believe that the inverted curve is one to look for because it is a good predictor of economic slowdown. The formation of this curve is rare so look out for it.