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Riding The Yield Curve

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CFD traders will often hear thephrase ?yield curve? used in long and short term evaluation of investmenttrends, and it is seen as important as one barometer for the outlook for theeconomy, and thus the stockmarket. The curve itself shows the structure ofinterest rates plotted over different maturities as measured by government ,from the shortest dated ,which usually are related to short term ,to long-dated i.e. 30 year plus maturities.

This enables investors firstly to beable to compare the yields offered by short-term, medium-term and long-termbonds. As there is usually a higher risk involved in choosing a longer datedmaturity, typically the yield curve should slop upward, but it is the actualslope that is of interest. This also has relevance for forex investors as itreflects one part of longer term currency risk evaluation.

The three shapes of the curve

The yield curve usually takes one ofthree shapes. If short-term yields are lower than long-term yields, the line ofinterest rates will slope upwards, and this is seen as normal.

If short-term yields are higher thanlong-term yields, the line then slopes down (at least at the beginning), andthis is referred to as an inverted or negative yield curve.

Occasionally, a flat yield curvereflects hardly any disparity between short-dated and long-dated yields.

What bonds are plotted?

It is very important that only bondsof similar risk are plotted on the curve, as the gap between low and high riskbonds itself is another factor for longer term investors to examine whenchoosing investments. In the US, the most common type of yield curve plotsTreasury securities because they are considered risk-free and are used as abenchmark for determining the yield on other types of higher risk debt. Theyield curves are calculated and published by The , the Federal Reserve, and a variety of other financialinstitutions.

In the UK, gilt stocks are used inthe same way and it is simple to compile current yield curves from theFinancial Times.

The importance of the yield curve

As mentioned above, when the yieldcurve is positive or sloping upwards, this indicates that investors require ahigher rate of return for the added risk of money for longer periods of time, which is normal.

If the yield curve shows a steepupwards slope, this indicates to some commentators that investors are lookingat strong future economic growth and potentially higher future inflation, whichmight lead to higher interest rates.

Changes in the shape of the yieldcurve can also have an impact on portfolio returns by making differently datedbonds more or less valuable relative to other bonds, so analysts and investorsneed to study yield curves carefully.

If there is a flat curve thisgenerally indicates that investors are unsure about future economic growth andinflation.

The inverted yield curve

This has been quite topical inrecent months as inverted yield curves have been seen in many economies afterthe period of steadily tightening monetary policy up until this summer.

Where there is an inverted yieldcurve this suggests that investors expect slowing economic growth andpotentially lower inflation. The inference here is to stave off possible recession, and this is what we have seenin the US earlier this month when the Federal Reserve lowered rates by 50 basispoints.

There have been many studies thathave found that inverted yield curves tend to precede recessions, but this maybe subject to revision given the prevailing fiat monetary policies in much ofthe developed world currently.

Yield curve theory

There are three main theories thatattempt to explain why yield curves are shaped the way they are, and it is forthe long term investor to decide whether these are relevant or superfluous tothe prevailing shape of the curve.

The expectations theorystates that expectations of rising short-term interest rates are what create apositive yield curve and vice versa.

The liquidity preferencehypothesis states that investors always prefer the higher liquidity ofshort-term debt and therefore any deviance from a positive yield curve willonly prove to be a temporary phenomenon.

The segmented market hypothesisstates that different investors confine themselves to certain maturity segments,making the yield curve a reflection of prevailing investment policies.

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