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A Guide to Exchange-Traded Australian Government Bonds

Nicholas Yaxley  |  19 Jun 2013Text size  Decrease  Increase  |  

Page 5 of 10

What is the Yield Curve?

The yield curve is a term which is commonly referenced, but not widely understood. A government bond yield curve begins with securities offering short-term interest rates (for example, cash) and extends out in time as far as the longest maturity (for example, 15-year bond). Typically, the yield curve is a representation of risk-free interest rates. In Australia, government bonds are used since these are considered to have effectively zero probability of default.

The yield curve is a line that joins a series of securities with different times to maturity. These securities are plotted on a graph and identify the relationship between the time to maturity and yield to maturity. The relationship between the levels of interest rates across different maturities is known as the term structure of interest rates. This "term structure" can be used to assess market expectations for growth and inflation and the future path of monetary policy.

 

Table 1: Example Yield Curve Data Points

Term to Maturity Yield to Maturity (%)  
1 Year 3.5  
3 Years 4.5  
5 Years 5.0  
10 Years 5.5  

 

Figure 4: Sample Yield Curve

Figure 4: Sample Yield Curve

Source: Morningstar analysts

 

The Shape of the Yield Curve

Figure 5 shows the typical variations of the yield curve, and how they are defined. A normal yield curve is one that slopes gently upward from left to right. It shows that yields are higher for longer-dated maturities than for shorter maturities. The reasoning is that the longer you invest your money, the more you should be rewarded for taking the extra risk.

 

Figure 5: Yield Curve Variations

Figure 5: Yield Curve Variations

Source: Morningstar analysts

 

Over time, the yield curve will change shape as the economic environment changes. It can be downward-slop ing (inverted) when expectations for future growth are negative, and upward-sloping when the growth outlook is positive. Here, we describe the types of yield curves:

Steep
A steep yield curve indicates that investors expect the economy to improve rapidly. This shape will typically appear at the end of a recession - when short-term interest rates have been set low by the central bank to encourage economic activity. However, fears about rising inflation would exist. As investors demand higher long-term interest rates to compensate for higher inflation, the curve steepens.

Normal
A normal yield curve, such as that discussed above, indicates that investors expect the economy to experience continued stable rates of growth without any major impact on the inflation rate.

Flat
A flat yield curve occurs when long-term interest rates are the same as short-term interest rates and can indicate an economic slowdown.  The curve can flatten if the economy has been growing rapidly and short-term rates are raised to try and slow things down. At the same time, long-term rates fall as investors expect inflation to moderate, and the curve flattens. Flat yield curves can appear when a normal yield curve transitions to an inverted curve, or vice versa.

Inverted
An inverted yield curve slopes downward (from left to right) and can indicate the start of a recession. This is an unusual situation and clearly defies logic: why would an investor accept a long-term interest rate that is lower than what is available in the short term? The reason is that investors expect interest rates to decline even further in the future and they wish to lock in rates before they fall even further.

 

The Neutral Interest Rate

Now that we understand what is driving the yield curve, the next point of understanding is where the curve is positioned relative to the neutral interest rate. Over the past few years, market participants have been actively defining the new neutral cash rate and whether or not the Reserve Bank of Australia's position is stimulatory or not relative to this level.

For the official cash rate to be expansionary, it must stimulate money supply in the wider economy. But this relationship does not work if the primary money lenders (banks) do not pass on the full amount to their clients. This leads to the current position where a 2.75% cash rate today is not as effective as a 2.75% cash rate five years ago.