Relationship between Yield Curve and Business Cycle

By:

Varsha Tushir (034)

Shilpa Deshwal (047)

The yield of a debt instrument is the overall rate of return available on the investment. For instance, a bank account that pays an interest rate of 4% per year has a 4% yield.

Yield Curve is the relation between the interest rate and the time to maturity of the debt for a given borrower in a given currency. 

A graphic line chart that shows interest rates at a specific point for all securities having equal risk, but different maturity dates .

Slope of an Yield Curve

The slope of the yield curve provides an important clue to the direction of future short-term interest rates; an upward sloping curve generally indicates that the financial markets expect higher future interest rates; a downward sloping curve indicates expectations of lower rates in the future

Business Cycle

Business cycle- is simply a means of describing the series of economic ups and downs that are part of the every business that operates over a number of years.

The four common expressions of the business cycle are the economic upturn, the economic peak, the economic decline, and the economic recovery.

Business Cycle

Stages in the Business Cycle

Economic upturn: is the most desirable phase, During this period, sales for the goods and services of the company are robust, with additional earnings posted from one period to the next.

Economic peak: During this cycle, the company is still profitable, but growth is minimal or non-existent.

Contd.

Economic decline: This cycle may occur due to the loss of customers to competitors, as a result of a recession that limits the disposable income of consumers, or marketing or expansion schemes that do not prove to be profitable for the company.

 Economic recovery: During this time business begins to overcome adverse circumstances that may have threatened the ongoing function of the enterprise. Profits begin to rise, laid off employees are called back to work.

some factors that shape business cycle

Volatility of investment spending Technological innovation Monetary policies Fluctuations in exports and imports

Types of Yield Curve

Normal Humped Inverted Flat

Normal Yield Curve

Normal yield curve- If short-term yields are lower than long-term yields (the line is sloping upwards), then the curve is referred to a positive (or "normal") yield curve.

Y is it Positive??

When the yield curve is positive- this indicates that investors require a higher rate of return for taking the added risk of lending money for a longer period of time. Many economists also believe that a steep positive curve indicates that investors expect strong future economic growth and higher future inflation (and thus higher interest rates).

Upward Sloping Yield Curve

Investors expect strong future economic growth and higher future inflation (and thus higher interest rates).

Flat and Humped yield Curve

Flat or humped yield curve-  flat yield curve is observed when all maturities have similar yields, whereas a humped curve results when short-term and long-term yields are equal and medium-term yields are higher than those of the short-term and long-term. A flat curve sends signals of uncertainty in the economy.

Humped yield curve

Flat Yield Curve

A flat curve generally indicates that investors are unsure about future economic growth and inflation.

Inverted Curve

Inverted yield curve - inverted yield curve occurs when long-term yields fall below short-term yields. Under unusual circumstances, long-term investors will settle for lower yields if they think the economy will slow or even decline in the future

Downward Sloping Yield Curve

Investors think the economy will slow or even decline in the future.

Characteristics of an Yield Curve

There are 3 characteristics of yield curve:The change in yields of different term bonds

tends to move in the same direction.The yields on short-term bonds are more

volatile than long-term bonds.The yields on long-term bonds tend to be

higher than short-term bonds.

The Expectations Hypothesis

This hypothesis assumes that the various maturities are perfect substitutes and suggests that the shape of the yield curve depends on investors expectations of future interest rates.

Rates on a long-term instrument are equal to the geometric mean of the yield on a series of short-term instruments.

Liquidity Premium Theory

The liquidity premium theory- explain the 3rd characteristic of the yield curve: that bonds with longer maturities tend to have higher yields. A longer term bond must pay a higher risk premium to compensate bondholder for the greater risk (inflation and interest risk ) ,

 Inflation risk reduces the real return of the bond. Interest rate risk is the risk that bond prices will drop if interest rates rise, since there is an inverse relationship between bond prices and interest rates.