Yield curves: an application
Interpreting the shape of the curves
The figure above shows the yield curve for government bonds with maturities up to 30 years for the US and the UK. It also shows the yield curve for the countries in the euro area as a whole, and for countries in the euro area with central governments rated AAA.
The curves are not directly comparable, because the yields apply to different currencies. However, we can interpret and compare the shapes of the curves, and comment on the general position of the curves.
What does the shape of the US yield curve suggest about the short- to medium-term strength of the US economy, inflation expectations, and the future pattern of short-term interest rates?
What do you conclude from the relative positions of the yield curve for AAA-rated governments in the euro area and the yield curve for the euro area as a whole?
How do you interpret the shape of the yield curve for the UK?
The term structure and risk management
The yield curve shows yields to maturity on central government bonds for a range of maturities, from a few months to 30 years (the Bank of England also publishes yields for 40 years to maturity).
The yields are related to how the bonds are priced in secondary markets. In Week 1 you saw how yield to maturity is the discount rate such that the discounted flow of cash payments associated with a bond is equal to the market price of the bond. Therefore bond prices and yields are influenced by expectations of future interest rates, inflation rates, and the risks facing the economy.
How much importance would you give to forecasts and expectations further into the future than six months? A year? Five years? Ten years?
Which decision makers would use these yield curves for risk management, and how?
You can probably think of a number of decision makers who manage risk over timescales of this length. The prices of long-term bonds, and yields to maturity up to 30 years, would influence their decision making.
Companies that borrow to finance long-term capital projects can choose to match the maturity of the debt with the timescale over which the projects are expected to generate revenue. The managers of pension funds need to match the maturity of the financial assets under management with the maturity of the pension liabilities.
In the country where you live, what is the longest time period over which it is possible to obtain a fixed-rate mortgage to purchase a house? Is a 30-year fix possible? Or desirable?
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