The Treasury Yield Curve, which is also known as the term structure of interest rates, draws out a line chart to demonstrate a relationship between yields and maturities of on-the-run treasury fixed income securities. It illustrates the yields of Treasury securities at fixed maturities, viz. 1, 3 and 6 months and 1, 2, 3, 5, 7, 10, 20 and 30 years. Therefore, they are commonly referred to as “Constant Maturity Treasury” Rates or CMTs.
Market participants pay very close attention to the yield curves, as they are used in deriving the interest rates (using bootstrapping) which are in turn used as discount rates for each payment to value treasury securities. In addition to this, market participants are also interested in identifying the spread between short term rates and long term rates to determine the slope of the yield curve, which is a predictor of economic situation of the country.
Yields on Treasury securities are in theory free of credit risk and are often used as a benchmark to evaluate the relative worth of US Non-Treasury securities. Below is the treasury yield curve chart as on October 3rd 2014.
The above chart shows a "Normal" Yield Curve, exhibiting an upward slope. This means that 30-year Treasury securities are offering the highest returns, while the 1-month maturity Treasury Securities are offering lowest returns. The scenario is considered normal because the investors are compensated for holding the longer term securities, which possess greater investment risks. The spread between 2-year US Treasury securities and 30-year US Treasury securities defines the slope of the yield curve, which in this case is 259 basis points. (Note: There is no industry-wide accepted definition of the maturity used for long-end and the maturity used for the short-end of the yield curve). The normal yield curve implies that both fiscal and monetary policies are currently expansionary and the economy is likely to expand in the future. The higher yields on longer term maturity securities also means that the short term rates are likely to increase in the future as the growth in the economy would lead to higher inflation rates.
Other Shapes of the Yield Curve
- Inverted Yield Curve: This occurs when short term rates are greater than the long term rates. It would generally imply that both monetary and fiscal policies are currently restrictive in nature and the probability of the economy contracting in the future is high. According to empirical evidence, the Inverted Yield curve has been the best predictor of recessions in the economy.
- Humped Yield Curve: This occurs when yields on medium term US Treasury Securities are higher than the yields on long term and the short term US Treasury Securities. This reflects that the current economic condition is unclear and the investors are uncertain about the economic scenario in the near future. It could also reflect that monetary policy is expansionary and fiscal policy is restrictive or vice-versa.
The Bottom Line
It is imperative for the market participants to view the Yield Curve to identify the future state of the economy, which would help them make relevant economic decisions. Yield Curves are also used to derive Yield to Maturity (YTM) for particular issues and play a crucial role in credit modeling, including bootstrapping, bond valuation, and risk and rating assessment.