Analyzing the Yield Curve - Essay Example

Analyzing the Yield Curve A yield curve is a graph which shows the relationship between the yields and maturities of bonds with similar risk. It’s also called as the term structure of interest rates since it describes the interest rates of bonds with different maturities. The yield curves are plotted from shortest to longest maturities. A yield curve should always exhibit the characteristic of bonds with similar riskiness. For instance, we cannot plot a yield curve using different maturities of treasury, municipal and corporate bonds.

The figure below shows the yield curve of US Treasury of 11th February 2011. The key point here is that only bonds with different maturities of US Treasury have been selected since they are default free and do not have credit risk associated with them. Despite the fact that these bonds are risk free than why the yield curve is positive sloping that is its yield is increasing with an increase in maturities. Figure 1: US Treasury bond yields as of Feb 11, 2011 (Source: www.bondsonline.com) Table 1: Yield on US Treasury bonds with different maturities The reason why it’s upward sloping is because the curve shows the expectations of the investors about future interest rates.

The investors require a higher rate of return as a compensation for lending their money for a longer period of time. In addition to that, the figure also reveals that as the Fed rate is currently on a very lower side therefore the market believes that in the future the returns will adjust due to inflation and other macroeconomic factors. This is more related with the expectations theory of the investors. The yield curve shifts over the period of time that is interest rate of different maturities increase or decrease on similar risk bonds.

This is for a number of reasons that causes shifts in yield curves. Firstly, the economic scenario in a country determines how the yield curve should behave. The Fed can increase or decrease the level of interest rates depending on the growth of economy. It can raise the interest rates, if it feels that the economy is booming and there is a high risk of inflation. Secondly, the fiscal policy of the country also plays a pivotal role in determining the interest rates.If the market considers that the government will be facing huge budget deficits, the investors will demand increasing compensation or required rate of return, as the supply of treasury bonds will grow to finance the budget which will push up the market interest rates for the long term as investors contemplate that the risk lies in the future.

Generally, we can infer why the yield curves are similar or different to each other. An upward sloping yield curve indicates that investor’s expectations about the future interest rates are higher because of strong economic growth and high inflation. A downward sloping yield curve will imply that investors have a negative view of the economic growth in the future. Whereas, a flat curve indicates that investors are uncertain about the future economic growth. References Bonds Online. (2011). Todays Market.

Retrieved February 11, 2011, from http://www.bondsonline.com/Todays_Market/Treasury_Yield_Curve.php