What is the “yield curve” and can this affect the economy?

Sep 23, 2020

Welcome to Finance and Fury, the Say What Wednesday edition. This week’s question is continuing on the from Raj in last week’s episode.

“I would love to have an overview of how certain economic factors are interlinked and impact economies”

This episode look at Yield curves and bond prices and touch on fiscal deficits

Last week – looked at the other factors – mainly CB policies including interest rates, inflation and the monetary supply – but can’t talk about these without the flow on effects that they have on what is known as the yield curve

1. The yield curve for government bonds is an important indicator in financial markets - helps to determine how actual and expected changes in the policy interest rate (the cash rate), along with changes in other monetary policy tools, feed through to a broad range of interest rates in the economy – hence can have affects on the entities that comprise an economy

The basics for bonds -

2. A bond is a loan made by an investor to a borrower for a set period of time in return for regular interest payments
   1. Known as a debt instrument –
   2. The time from when the bond is issued to when the borrower has agreed to pay the loan back is called its ‘term to maturity’.
   3. When the Government is the borrower – it is a Gov bond
   4. The main difference between a bond and a regular loan is that, once issued, a bond can be traded with other investors in a financial market directly – in the secondary market - As a result - a bond has a market price.
      1. True that mortgages can be traded as well – but it is after they are packed up by a financial institution and traded in a product like a MBS – however – bonds don’t need this securitisation step
   5. Bond yields - is the return an investor expects to receive each year over the bonds term until it reaches the maturity date
      1. For the investor (who has purchased the bond) - the bond yield is a summary of the overall return that accounts for the remaining interest payments and principal they will receive, relative to the price of the bond
         1. Say that the bond is paying a coupon of 1% over a year – and the bond is maturing in 1 years time – the investor will get $100 back and the current price of the bond is $99 – the total yield will be close to 2%
      2. For the borrower (entity that issued the bond) - the bond yield reflects the annual cost of borrowing funds through issuing a new bond
         1. For example, if the yield on three-year Australian government bonds is 1% - means that it would cost the Australian government 1% each year for the next three years to borrow in the bond market
      3. So there is a difference when talking about the bond yields for the investor or borrower
   6. Relationship between a bond and its yield - The prices at which investors buy and sell bonds in the secondary market move in the opposite direction to the yields they expect to receive
      1. Once a bond is issued - it offers fixed interest payments to its owner over its term to maturity – say the coupon payments are going to be 1% p.a. and it is a 10-year bond – get 1% p.a. for 10 years
      2. However - interest rates change all the time = as a result, new bonds that are issued will offer different coupon payments to investors when compared existing bonds that were issued 5 or 10 years ago
         1. In the current economic environment – created a situation where as interest rates are falling – older bonds have become more valuable to investors due to the higher coupon payments – hence the price of existing bonds will rise when compared to newly issued bonds
         2. However, if a bond's price increases it is now more expensive for a potential new investor to buy – so the bond's yield will then fall because the return an investor expects from purchasing this bond is now lower –
      3. Example - consider a government bond issued in mid-2019 with a 10 year term - The principal of the bond is $100 – so on 30 June 2029 the government must repay $100 dollars to the bond's owner
         1. The bond has an annual coupon payment of 2% of the principal (i.e. $2 each year).
         2. Imagine that the cash rate falls – and so does the coupon on newly issued bonds – Governments are similar to households – if the cash rates go down – we want to be able to borrow at lower rates – only major difference is one does it from banks and the other from investors – however investors have little choice as cash returns also fall –

• If new bonds now pay coupon payments of 1% (or $1 p.a.) – However – the older bond still offers a $2 annual income – with basic maths this is $1 in excess of what new bonds will pay - As a result – investors will be willing to pay more than $100 to purchase the older bond – hence the price pay increase above the Face Value of $100 – with a 10 year maturity (now just under 9 years until maturity) - The price of the bond will actually be close to $109

1. But you can see in this example – that if you are paying more than the bond is worth – get back $100 in just under 9 years – but you are paying $109 for it – your yield is actually close to 1% - the additional $9 you get from the income will be negated by the additional $9 that you pay for the bond – so in essence – the price of the bond forms part of the yield curve

5. The yield curve - shows the yield on bonds over different terms to maturity – it is a way of plotting the expected return of a bond over the life of the bond in a visual way – in graph form with the yield on the y (or vertical) axis and the date (maturity) on the x-axis – or horizontally
   1. To graph the yield curve - the yield is calculated for all government bonds at each term to maturity remaining
      1. For example, the yield on all government bonds with one year remaining until maturity is calculated - this value is then plotted on the y-axis against the one-year term on the x-axis – then you do this for the yield on all bonds for two years, then 3 years, all the way up to 30 years or 50 years
      2. Now – the cash rate forms the beginning of the government yield curve – due to this interest rate having the shortest term in the economy (as it is overnight)

• So normally – the yield curve is upwards sloping – goes from a low cash rate to the longer term maturities

1. However – there can be different shapes to the curve based around the level and the slope of the curve
   1. The level refers to the cash rate – the higher the cash rate – as the first point on the curve – the higher the level of the yield curve will be – think of values along the y-axis of a chart – 0.25% compared to 5% - hence the cash rate is the anchor of the yield curve
      1. Due to being the anchor – changes in the cash rate affect the whole yield curve upwards and downwards due to the future influences on the starting point for yields
   2. The slope - reflects the difference between yields on short-term bonds (e.g. 1 year) and long-term bonds (e.g. 30 year) – however this slope reflects the expectations on the fact that the cash rates might differ between now and the future - which are uncertain – However these expectation by the market translate into actual outcomes based around the pricing on debt in the markets – Types:
      1. Normal yield curve - where short-term yields are lower than long-term yields - so the yield curve slopes upward - considered a normal shape for the yield curve because bonds that have a longer term are more exposed to the uncertainty that interest rates or inflation could rise at some point in the future (if this occurs, the price of a long-term bond will fall); this means investors usually demand a higher yield to own longer-term bonds – A normal yield curve is often observed in times of economic expansion, when economic growth and inflation are increasing. In an expansion there is a greater likelihood that future interest rates will be higher than current interest rates, because investors will expect the central bank to raise its policy interest rate in response to higher inflation
      2. Inverted yield curve - An ‘inverted’ shape for the yield curve is where short-term yields are higher than long-term yields - so the yield curve slopes downward – likely to be present when investors think it is more likely that the future policy interest rate will be lower than the current policy interest rate - an inverted yield curve has historically been associated with an anticipated economic contraction – mainly because the anticipated response of central banks reducing interest rates in response to lower economic growth and inflation, which investors may correctly anticipate will happen
      3. Flat yield curve - A ‘flat’ shape for the yield curve occurs when short-term yields are similar to long-term yields. A flat curve is often observed when the yield curve is transitioning between a normal and inverted shape, or vice versa. A flat yield curve has also been observed at low levels of interest rates or as a result of some types of unconventional monetary policy.

• Hence – the slope of the curve is use to help anticipate the health of an economy – if up – things are likely to improve due to rates likely increasing – if it is downwards sloping (inverted) – rates are expected to drop due to CB policy to help boost the economy

 

Why is the yield curve important – can it actually have an effect on the economy?

The yield curve receives a lot of attention from those who analyse the economy and financial markets. The yield curve is an important economic indicator because does provide information to participants in the market:

1. The yield curve for government bonds is also called the ‘risk free yield curve’ - The expression ‘risk free’ is used because governments are not expected to fail to pay back the borrowing, they have done by issuing bonds in their own currency – this is an important part of financial markets – pricing assets using the RF rate as a discount – so it can affect asset prices – not the curve itself – but the information it contains
2. YC is central to the transmission of monetary policy – in the form of interest rate movements in the economy
   1. When households, firms or governments borrow from a bank or from the market (by issuing a bond), their cost of borrowing will depend on the level and slope of the yield curve
      1. A bank would calculate the interest rate on their fixed rate mortgages by taking the relevant term on the risk-free yield curve – if they are offering 3-year fixed rates – they would look at the three-year term on the yield curve when calculating how much to charge
      2. So the yield curve influences the interest rate fixed rate loans but also on savings products with a fixed term, such as term deposits.
   2. Outside of individuals - Different terms of the yield curve are important for different sectors of the economy
      1. In the previous example – individuals may only be able to lock in their interest rate for 2–3 years, so this part of the yield curve is important for fixed mortgage rates.
      2. However - Many Australian households have mortgages with variable interest rates, so the cash rate is important for them today

• On the other hand, companies as well as the government often wish to borrow for a much longer term, say 5 or 10 years at a fixed rate - so this part of the yield curve is important for them

3. So the yield curve provides a source of information about investors' expectations for future interest rates, as well as economic growth and inflation
   1. In financial markets, the slope of the yield curve (e.g. normal, inverted, flat) provides an important signal of investors' expectations for future interest rates, and by extension their expectations for future economic growth and inflation – hence the slope of the yield curve is considered to be a ‘leading indicator’ of future economic growth and inflation – this is due to financial markets being a forward-looking environment – markets try to price in future data today to make profits
4. The curve can be a determinant of the profitability of banks – through both the level and slope of the yield curve
   1. In an ideal world - banks support the growth of credit (lent money) in the economy - which is an important factor for economic growth when used appropriately for investment (especially business)
      1. Think it is obvious that banks earn profits from lending funds at a higher interest rate than they pay cover the costs of funding their lending (tier 1 capital or paying depositors) – However - Banks usually lend for longer terms in the form of 30 year mortgages than what they are covering in the costs of the tier 1 capital - so part of this profit comes from the difference between long-term and short-term interest rates (i.e. the slope of the yield curve)
      2. If the yield curve is normal, all else equal, a steeper slope will mean a larger margin and higher profits for the banking system – this is a major consideration in countries like the US with long term fixed rates

• However - In Australia, the interest rate on many loans is based on the shorter-term end of the yield curve – due to variable rate mortgages - so the slope of the yield curve has less of an effect on bank profitability – hence why our banking system does better in the current economic environments

5. Fiscal deficits – do play a part – as these are funded through bonds – so if yield curve is inverted – means Govs can easily fund long term deficits and may prefer to wait before issuing bonds –
   1. However – who would want to buy bonds in this world when the curve starts to become inverted – well – welcome to the necessity of QE – have CBs buy back bonds off the markets – if you can create the money out of thin air and it is part of your monetary policy – doesn’t matter to them

In summary – whilst the yield curve doesn’t directly affect the economy – it is used as an indicator to base economic decisions around – so indirectly affects the economy based around the actions that individuals take due to the information portrayed

1. Comes in the form of valuation for assets using it as the risk free rate
2. Also shows the expectations of the markets on what the future has in store for economic growth and inflation – hence investors will make decision today based around what is expected in the future
3. Also shows the potential impact of the banking systems profitability as well as the incentives to raise funds now or later for governments through issuing bonds.

In next episode – finish up – focusing a bit on fiscal deficits more and then the real inputs to the economy, like forex, oil prices and trade imbalances

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/