Yield Curve Definition, Types, Theories and Example
When this occurs, fixed-rate loans can be more attractive than adjustable-rate loans. From an economic perspective, an inverted yield curve suggests that the near term is riskier than the long term. However, it does not require the distinct markets assumption rather it presumes that investors are willing to go out of their preferred habitat (preferred maturities) if doing so would result in higher risk-adjusted return.
An inverted yield curve appeared in August 2006, as the Fed raised short-term interest rates in response to overheating equity, real estate, and mortgage markets. The inversion of the yield curve preceded the peak of the Standard & Poor’s 500 in October 2007 by 14 months and the official start of the recession in December 2007 by 16 months. More recent research has delved into the realm of Behavioural Economics; this field acknowledges systematic cognitive biases exhibited by individuals while forming expectations and making decisions.
Difference Between Expectations Theory and Preferred Habitat Theory
Debt with longer maturities typically pay higher interest rates than nearer-term ones. An inverted yield curve is just opposite of the normal yield curve (therefore, it is also called abnormal yield curve). When the yield for shorter maturities is higher than the yield for longer maturities, the yield curve slopes downward and the graph looks inverted.
For instance, suppose there is a consensus that inflation will accelerate in the following year. In that case, firms might increase their prices, workers could demand higher wages, and bond investors could require higher yields to compensate for the anticipated decrease in purchasing power. Another limitation of the theory is that many factors impact short-term and long-term bond yields. The Federal Reserve adjusts interest rates up or down, which impacts bond yields, including short-term bonds. However, long-term yields might be less affected because many other factors impact long-term yields, including inflation and economic growth expectations.
In any case, the COVID-19 downturn quickly rebounded to new record highs. Economic cycles, regardless of their length, have historically transitioned from growth to recession and back again. Inverted yield curves are an essential element of these cycles, preceding every recession since 1956. It has been refined and built upon over time through rigorous research and innovative studies. These advancements allow the theory to better incorporate real-world considerations and present a more comprehensive picture of economic dynamics.
This theory is fundamentally concerned with how expectations about future economic events influence present-day behaviour and decision-making. From influencing policy decisions to playing a critical role in shaping market dynamics, the expectations theory offers valuable insights into a multitude of macroeconomic phenomena. While traditional term structure tests mostly indicate that expected future interest rates are ex post inefficient forecasts, Froot (1989) has an alternative take on it.[4] At short maturities, the expectation hypothesis fails. At long maturities, however, changes in the yield curve reflect changes in expected future rates one-for-one. The pure expectations theory serves as a model to calculate the forward exchange rates and rates of interest.
How Well Do Inverted Yield Curves Predict a Recession?
A yield curve is a graphical presentation of the term structure of interest rates, the relationship between short-term and long-term bond yields. It is plotted with bond yield on the vertical axis and the years to maturity on the horizontal axis. A third limitation is the inherent difficulty in testing the predictions of the Expectations Theory. Given the theory is dependent on individual expectations of future events, which are inherently unobservable, empirical investigation is challenging. Furthermore, while surveys can provide some information about expectations, they are constrained by subjective biases and inaccuracies. To conclude, the Expectations Theory has a fundamental role in interpreting and predicting market behaviours in a wide range of scenarios.
There would, thus, be no ex-ante bias whatsoever for the slope of the Yield Curve. However, the unbiased expectations theory assumes that the net profit should be equal. One of the most widely used forms of the hypothesis model is the unbiased expectations theory. This implies that an investor putting in a 1-year bond with a 9% current rate should expect it to give 11.1% in the next year to get an equivalent return of a 2-year bond. It can be predicted with an analysis of the term structure of interest rates.
Introduction to Financial Analysis
She has worked in multiple cities covering breaking news, politics, education, and more. It even “predicted” the economic downturn that followed the COVID-19 pandemic (although most economists attribute this to luck, and not the fact that it can predict natural disasters). The inversion followed shortly after the Federal Open Markets Committee began raising the target federal funds rate to control inflation. The trend peaked in coinberry review July 2023 after a series of interest rate hikes by the Federal Reserve. Despite their consequences for some parties, yield-curve inversions tend to have less impact on consumer staples and healthcare companies, which are not interest-rate dependent.
If the investor chooses to invest in a one-year bond at 18%, the bond yield for the following year’s bond would need to increase to 22% for this investment to be advantageous. Treasuries has predicted every recession since 1955, with only one false signal during that time. Homebuyers financing their properties with adjustable-rate mortgages (ARMs) have interest-rate schedules that are periodically updated based on short-term interest rates. When short-term rates are higher than long-term rates, payments on ARMs rise.
Two economic theories have been used to explain the shape of the yield curve; the pure expectations theory and the liquidity preference theory. The yield curve slopes upwards, reflecting higher yields for longer-term investments. The segmented market theory argues that the term structure is not determined by either liquidity or expected spot rates. Instead, the shape of the yield curve is solely determined by the preference of borrowers and lenders. The yield curve at any maturity simply depends on the supply and demand for loans at that maturity. The yield at each maturity is independent of the yields at other maturities.
- They would sell the other, which would have, in the end, an equal and opposite effect.
- The unbiased expectations theory or pure expectations theory argues that it is investors’ expectations of future interest rates that determine the shape of the interest rate term structure.
- During these times, expectations can quickly change, and the resulting market action may not follow the traditional norms described by the Expectations Theory.
- There would, thus, be no ex-ante bias whatsoever for the slope of the Yield Curve.
Understanding Expectations Theory
Money market funds and certificates of deposit (CDs) may also be attractive – particularly when a one-year CD is paying yields comparable to those on a 10-year Treasury bond. Yield curves differ primarily based on their underlying type of yield i.e. treasury yield, corporate bond yield, etc. Furthermore, advancements in both economic theory and empirical methodologies have enabled economists to test the predictions of the Expectations Theory more rigorously using micro-level data. Such research is crucial to improving the validity and reliability of the theory. Its complexity sometimes leads to erroneous interpretations and misconceptions.
As concerns of an impending recession increase, investors tend to buy long Treasury bonds as a safe harbor from falling equities markets. As a result of this rotation to long maturities, yields can fall below short-term rates, forming an inverted yield curve. This theory argues that forward rates represent expected future spot rates plus a premium. The preferred habitat theory argues that, if there are imbalances between supply and demand at a particular maturity, then investors are willing to shift habitat in exchange for a premium.
A steep yield curve signals that the interest rates are expected to be increase in future. This is represented by the black line corresponding to a period in 2013. The Expectations Theory suggests coinberry review that individuals and firms adjust their behaviour according to chronic inflation or deflation expectations.