Yield Curve

Table of Content

1.Different durations of maturity create a yield curve

In the US, there are different types of bonds, namely (1) Treasury Bills, more colloquially known as T-bills, (2) Treasury notes, T-notes, and (3) Treasury bonds, T-bonds.  They are IOUs secured by the US government and often considered to be the safest investment instruments. They differ, depending on the durations of maturity and are typically 6 months-1 year, 1-10 years, and 10-30 years, respectively.

As a rule of thumb, the longer the holding period is, the riskier the securities are, as the distant future is more uncertain than the near future, therefore yields tend to be higher in order to attract more investors. Below shows the current Treasury yield rates (Fig.1).

Fig.1. Daily Treasury Yield Curve Rates

Date 1 Mo 2 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr
12/03/18 2.30 2.35 2.38 2.56 2.72 2.83 2.84 2.83 2.90 2.98 3.15 3.27
12/04/18 2.37 2.42 2.42 2.58 2.71 2.80 2.81 2.79 2.84 2.91 3.05 3.16

Source: U.S. Department of the Treasury, Tuesday December 4, 2018

When the rates are plotted, the trajectory shows a curve. For instance, when recent rates are plotted, the following graph shows curves (Fig.2). 

Fig.2. Yield Curves

Source: U.S. Department of the Treasury, Tuesday December 4, 2018e

For the healthy working of a financial market, it is critical to have the gap between the bonds with longer durations of maturity and the ones with shorter durations of maturity, as long-term debts such as mortgages, for instance, rely on the gap (Rennison and Wigglesworth, 2018). A normal yield curve, trending upward, is usually welcoming news for homeowners with mortgages, as it shows the market’s expectation of inflation, and their home values are likely to increase (Chen, 2018 Feb). In this case, the difference, or the spread, between longer-term Treasuries and shorter-term ones is positive.

T-bonds >T-bills,  the spread >0

2.Secondary Market and OTC

Those government bonds are traded as financial instruments, just as other financial instruments. The trade and exchange of them take place both in the formality of exchange markets like New York Stock Exchange, as well as more informal places, commonly called over the counter (OTC), which takes place between two parties anywhere outside of exchange markets, but often via a dealer network (Chen, 2018 Aug). In fact, bonds are more commonly traded OTC for the reason that there are many varieties (Morah, 2018).

3.The basic mechanism of Bonds 

As such, bond prices change, but what are the implications of the fact that bonds can be bought and sold in terms of the relationship between yields and prices? 

3.1.Coupon Rate 

Buying bonds essentially means for investors to lend money to bond issuers, i.e., the government, and in return, bond issuers agree to pay investors interest on bonds through the life on the bond, and upon its maturity, to repay its face value. The simplest way to calculate a bond yield is called the coupon rate (Investopedia, 2018).

If the face value of a bond is $1000 and the annual coupon payment is $100, the coupon rate (or nominal yield) is 10%. Or to put it differently, if the face value of a bond is $1000 and the coupon rate is 10%, the annual coupon payment is $100.

3.2.Current Yield

As mentioned, however, since bonds are bought and sold as financial instruments and thus bond prices change, coupon rates become rather irrelevant. Now, bond yields and bond prices are in an inverse relationship. That is, as bond prices rise, bond yields fall, and vice versa. 

If interest rates increase above 10%, the price of a bond falls if it is sold. In the earlier case, where the coupon rate is 10% and the face value of a bond is $1000, if interest rates for similar investments rise to 12%, the original bond still yields only a coupon payment of $100, instead of $120 like the other investments. It means that the bond with a 10% yield is unattractive to investors who can now buy bonds that yield 12%. If the original bondholder is to sell it, the price has to be reduced to make it competitive. It means, in this case, that the investor has to drop the price of the bond to $833.3. 

 When interest rates rise, the bond’s price fall. Whereas, if interest rates fall, the bond’s price rises, as the coupon payment remains the same. If interest rates fall to 8%, for example, the original bondholder can now sell it for $1250.

By using current yield, now, investors can obtain a rough estimate of the bond’s true yield. 

3.3. Yield to Maturity

That said, the shortcomings of the current yield or the coupon rate for that matter is that they do not take into account the time-value of capital, maturity value, or payment frequency. 

A bond’s yield to maturity (YTM), on the other hand, takes into account the interest rate that makes the present value of a bond’s all future cash flows, including all the coupon payments and its maturity value, while it calculates them all to its current price (Investopedia, 2018). YTM is the total return anticipated on a bond if the bond is held until it matures. It can be said that YTM is the internal rate of return (IRR) of an investment in a bond if the bond is held till its maturity (Investopedia, 2018).

n = number of years to maturity

Face value = bond’s maturity value or par value

Current price = the bond’s price today

4. Flattening of a yield curve

If the rate of a short-term Treasury, such as the 3-month T-bill, increases relative to the rate of longer-term bonds like the T-note, then the yield-curve becomes flat (Chen, 2018 Feb). A flat yield curve typically indicates that investors are worried about macroeconomic outlook because either market participants are expecting inflation to drop or the Federal Reserve to raise near-term interest rates (Chen, 2018 Feb). In other words, a flat yield curve may indicate that a business cycle is coming to a late stage and a central bank begins to tighten a monetary policy.

5. Yield Curve Inversion

And if a yield curve becomes inverted, it means that short-term rates exceed the long-term ones, making the spread between the yield on longer-term bonds and shorter-term bonds rather negative. 

T-bonds < T-bills,  the spread < 0

Again, it is merely a general rule of thumb, however, statistically speaking, the inversion of a yield curve has been a fairly reliable indicator of an impending recession (Chen, 2018 Dec). Since 1957, every recession has been preceded by a yield curve inversion, although every yield curve inversion did not necessarily result in a recession (Famiglietti and Garriga, 2018; Chen, 2018 Dec). As mentioned, an inverse yield curve predicts lower interest rates in the future due to weak economic activity, while longer-term bonds are being demanded, pushing the prices up, and sending the yields down (Chen, 2018 Dec). That is, by issuing longer-term securities with lower-yield offerings, businesses and governmental institutions can obtain necessary investment capital at affordable costs to kick-start a weakened or weakening economy (Chen, 2018 Dec). 

Moreover, what drives yields in the market is varying demands for securities of different maturities at a specific time under impending economic conditions. When an economy is deemed to be heading to a recession, knowing that interest rates will be lowered, investors are more incentivised to invest in longer-term securities immediately to lock in current higher yields. In response, this pushes up the demand for longer-term securities, boosting their prices and accordingly further lowering their yields (Chen, 2018 Dec). 

On the other hands, fewer investors now want to invest in shorter-term securities when presented with lower reinvestment rates, which naturally weighs on demand. With lower demand for shorter-term securities, as explained earlier, their yields climb up (Chen, 2018 Dec).  

To summarise, a yield curve measures investors’ expectation of economic growth within a country at the present point in time in relation to economic growth in the future. When a yield curve is inverted to be negative, it implies that the expectation of the current economic growth is greater than that of the future. That is to say, investors expect the future economic growth to be worse than the present one, expecting stagnation, slowing down, and perhaps a recession.

In earlier December 2018, a series of near-correction tumbles that had preceded in the equity market lay heavy on longer-term Treasury yields, driving investors to price in the likely scenario of fewer rate hikes in 2019, which was further accelerated by the Fed chairman Jay Powell’s dovish comment on Wednesday 28 November 2018 as to interest rates (Rennison and Wigglesworth, 2018). Following that, in the light of the logic elucidated above, the quick inversion of the spread between the 2-year and 5-year Treasuries was observed (Rennison and Wigglesworth, 2018).

Fig.4. Inversion of the Treasury yield curve between the 2-year and 5-year T-notes

Source: The Financial Times (Rennison and Wigglesworth, 2018)

Yield Curve Control (YCC) Scheme in Japan

6. QQE in Japan

This dynamic, however, can be manipulated when a country is adopting a monetary policy that involves quantitative easing (QE), whereby financial products, such as government bonds circulating in the market are bought by a central bank in order to inject extra liquidity into the market when a deflationary spiral is experienced and it is urgent to stimulate people’s animal spirit in order to encourage consumption. Since one’s consumption is a profit for another, in theory, once consumption increases, the economic machine becomes up and running. 

Japan is a country that has adopted this monetary policy in recent years with the unprecedentedly audacious QQE programmes. And near-term bond yields have kept near zero, but why the bond yields have been so low? 

The reason why the Japanese government bonds (JGBs) have been extremely low is because the monetary policy of BOJ focuses on the yield curve. Since 2012, BOJ has embarked on an unprecedented level of quantitative and qualitative monetary easing (QQE) that encompasses an enormous volume of asset buying (Fujiki and Tomura, 2017). 

By buying up the JGBs, BOJ has pumped trillions of yen into the domestic economy over the past 6 years in order to stimulate consumption with the goal of achieving the inflation of 2% (Fujiki and Tomura, 2017). And now, BOJ is running out of the JGBs to buy, therefore they began to buy ETFs (Index-linked Exchange Traded Funds), which is linked with TOPIC and REIT (Real Estate Investment Trust) (BOJ, 2018; Fujiki and Tomura, 2017).

BOJ has instituted an innovative monetary policy to anchor the yield curve at around 0% in order to keep the borrowing cost low. In fact, prior to the commencement of the QQE, the JGB yields had already been lowered since late February 2013. The 10-year yield, for example, began its descent from 0.7-0.8% in late February 2013 to 0.6% in mid-March 2013 (Shirai, 2018, p.66). (Fig.3) 

Fig.3: JGB yields between 2006 and 2016 (%)

Source: Ministry of Finance; Shirai, 2018, p.67

JGB: Japanese Government Bond

QQE: Quantitative and Qualitative Monetary Easing

By keeping the bond yields at near zero, BOJ has been able to buy many JGBs. Now, BOJ’s balance sheet consists of $4.53 trillion of holdings, of which 85% are JGBs (Allen and Fray, 2017).

So why this was thought to be the way to reduce the mounting national debt and resolve the deflationary trend that has perpetuated for decades?

7. Yield Curve Control (YCC) Scheme

While the yield curve is anchored at near zero, the Yield Curve Control(YCC) involves the targeted manipulation of longer-term government bond rates to ensure a steep curve, as shown in Fig 4 (Monfort, 2018). The measure was somewhat successful in assisting Japanese banks to regain profitability, as banks had suffered from extremely low, long-term interest rates, which resulted in margin erosion (Monfort, 2018). As mentioned earlier, the yield curve with a positive spread ensures the healthy functioning of the financial market. Thus, having a steep curve, even with a small spread, is pivotal in helping banks to recover.

Fig.4: JGB Yield Curve

Source: Bloomberg, 2018; Japan Macro Advisors, 2018, Dec 25  

Bank deputy governor Masayoshi Amamiya was the main architect of the eye-popping asset-buying programme with low or negative interest rates, and he has also been the one to undo it as well. The increased flexibility was brought forth as a compromised policy between the governor Kuroda and the more hawkish deputy Amamiya (Monfort, 2018). BOJ has adopted more subtle means of monetary tightening, by allowing some leeway in the Yield Curve Control (YCC) scheme, which has been at work for nearly a year, and this is the mechanism for unwinding the unprecedented stimulus programme (Monfort, 2018). 

As in the DCF, the discount cash flow method, the time factor of the cost of capital is taken into account over a period of time. The interest rate constitutes a large part of a discount rate, which means that for corporations when an interest rate is high, cost of borrowing becomes also high. When the cost of borrowing is high, it deters investment in any future projects. In order to stimulate an economy during a deflationary trend, it is critical to ensure that large investments in future projects are made, thus a central bank tends to lower interest rates to incentivise such investments. 

Given that, unwinding the QQE poses a serious challenge. As a tightening policy, raising interest rates, for example, would likely trigger a spike in the currency, which would stain Japanese exporters that underpin the Japanese economy. Whereas, leaving it too long may ignite an inflationary risk. 

The BOJ has thus far taken ever-more gentle approach to unwinding the stimulus programme, as the yield curve has steepened very gradually. If it steepens too quickly, it will send long-term JGBs down in price, while it will then strengthen JPY and exports will suffer. Thus, the current pace is the speed at which the BOJ finds manageable (Monfort, 2018). 

Diagram 1: The Unwinding of the Stimulus – the Yield Curve Control (YCC) scheme

8. Liquidity trap 

Since the interest rates have been near zero for many years, where bonds and cash are essentially equal, monetary policies implemented by a central bank become less effective. This is known, in classic Keynesian economics, as a liquidity trap (Krugman, 1998). Currently, there is little room left for BOJ to manoeuvre in terms or monetary policies, while, out of desperation, printing money and thereby buying financial assets circulating in the markets in order to inject extra liquidity. And this time, by means of raising the inflation rate, it aims to reduce the mounting sovereign debt and boost productivity. Nevertheless, the context in which Keynes proposed this idea, i.e., the early 1930s was, in many ways, different from today’s economic situation in Japan. 

What has been implied here is that despite extremely low interest rates, the GDP growth has been disappointing due to low consumption in the face of the soaring sovereign debt due to the QQE (Coppola, 2018). In fact, Japan’s debt to GDP reached 253% in 2017 (Trading Economics, 2018). (Fig.6). Government debt as a percentage of GDP measures a country’s ability to make future payments on its debts, affecting the country’s borrowing costs and government bond yields (Trading Economics, 2018). 

Fig.7. Japan General Government Gross Debt to GDP

Source: Trading Economics, 2018

9.Exhausted ammunition & Risk of imploding

For the purpose of reaching the inflation target of 2% in an attempt to curb out their mounting national debt and rejuvenate the deflationary trend, BOJ has been buying JGBs, so many that their balance sheet has been elevated to a dangerous territory, as seen above (Fig.7). 

However, as the era of easy money seems to be coming to an end, BOJ will at some point be forced to tighten its monetary policy, otherwise capital will flow from Japan to other countries with higher interest rates. It means, nonetheless, that all JGBs and other assets that BOJ has accumulated will inevitably become bad debts, exceeding the level of interest payments that the government can keep up, thus its balance sheet becomes utterly unsustainable (Shirai, 2018; Fujiki and Tomura, 2017). 

Also, it is dangerous for interest rates to be kept near zero because it means that there is little room left for the central bank to be able to manoeuvre in order to intervene the economy when a crisis strikes, leaving the economy extremely vulnerable to any external shocks, or some seemingly insignificant event, which could tip the current apparent equilibrium. 

As the Fed continues to hike interest rates in 2019, the US bond yields continue to go up, making it more attractive than other countries’ bonds, including that of Japan. As a result, more money and credit will flow into the US economy and out of other less attractive countries including Japan. In August 2018, Japan’s bond yield popped up to 0.1%, and it continued to rise to 0.112 (Dye and Wigglesworth, 2018). It was the highest in the prior 18 months (Reid, 2018). Raising Japanese bond yields, even to 0.1% then, was BOJ’s posturing to put a lid on cash flowing out of the country, despite BOJ’s monetary policy to keep the bond yields at near 0%.

The truth of the matter is that BOJ has long run out of any viable ammunitions. Without available ammunition, Japan’s economy will remain extremely vulnerable to external forces, particularly when the sign of a recession is vaguely looming on the horizon in the US and beyond. 

10.References

Allen, K. and Fray, K. (2017, Aug 15). Central banks hold a fifth of their governments’ debt. Financial Times. Retrieved from: 

Allen, K. and Fray, K. (2017, Aug 15). Central banks hold a fifth of their governments’ debt. Financial Times. Retrieved from: 

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Chen, J. (2018, Aug 4). Over-The-Counter – OTC. Investopedia. Retrieved from: https://www.investopedia.com/terms/o/otc.asp

Chen, J. (2018, Feb 14). Flat Yield Curve. Investopedia. Retrieved from: https://www.investopedia.com/terms/f/flatyieldcurve.asp

Chen, J. (2018, Nov 15). Yield to Maturity (YTM). Investopedia. Retrieved from: https://www.investopedia.com/terms/y/yieldtomaturity.asp

Chen, J. (2018, Dec 14). Inverted Yield Curve. Investopedia. Retrieved from: https://www.investopedia.com/terms/i/invertedyieldcurve.asp

Coppola, F. (2018). Japan’s Lowflation Problem. Forbes. Retrieved from: https://www.forbes.com/sites/francescoppola/2018/07/31/japans-lowflation-problem/#28c009f63d64

Dye, J., and Wigglesworth, R. (2018). US 10-year bond yield hits 3% ahead of Fed decision. Financial Times. [Online] August 1. Retrieved from: https://www.ft.com/content/7d440504-9588-11e8-b747-fb1e803ee64e

Famiglietti, M., and Garriga, C. (2018, Oct 11). The FRED Blog: The Data behind the fear of yield curve inversions. The Federal Reserve Bank of St. Louis. Retrieved from: https://fredblog.stlouisfed.org/2018/10/the-data-behind-the-fear-of-yield-curve-inversions/

Fujiki, H. and Tomura, H. (2017). Fiscal cost to exit quantitative easing: the case of Japan. Japan and the World Economy42, pp.1-11. 

Investopedia. (2018). Bond Yield. Retrieved from: https://www.investopedia.com/terms/b/bond-yield.asp

Kihara, L. (2018, 25 September). BOJ’s Kuroda highlights need to look at downside of easy policy. Reuters. Retrieved from: https://www.reuters.com/article/us-japan-economy-boj/bojs-kuroda-highlights-need-to-look-at-downside-of-easy-policy-idUSKCN1M50K0

Krugman, R.P. (1998). It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap. Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol.29 (2), pp.137-206.

Monfort, J. (2018, August 08). Japanese Yen Rises After Wage data Surprise and BOJ Tightening Rumours Drive Outlook. PoundSteling Live. Retrieved from:

Morah, C. (2018). Why are most bonds traded on the secondary market “over the counter”? Investopedia. Retrieved from: https://www.investopedia.com/ask/answers/09/bond-over-the-counter.asp

Reid, H. (2018). BoJ easing talk sends bond yields up. Reuters. Retrieved from: https://www.reuters.com/article/global-markets/global-markets-boj-easing-talk-sends-bond-yields-up-idUSL5N1UJ2FY

Rennison, J., and Wigglesworth, R. (2018, July 25). Flattening yield curve stirs US recession fears. Financial Times. Retrieved from: https://www.reuters.com/article/us-global-markets/bond-yields-rise-on-boj-easing-talk-while-stocks-slide-idUSKBN1KD01E

Shirai, S. (2018). Mission Incomplete: Reflating Japan’s Economy. 2ndedition. Asian Development Bank Institute. 

U.S. DEPARTMENT OF THE TREASURY. (2018). Resource Center: Daily Treasury Yield Curve Rates. Retrieved from: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

Trading Economics. (2018) Japan General Government Gross Debt to GDP. Retrieved from: https://tradingeconomics.com/japan/government-debt-to-gdp

Bloomberg. (2018, July 31). Japanese Rates & Bonds. Bloomberg. Retrieved from: https://www.bloomberg.com/markets/rates-bonds/government-bonds/japan&nbsp;

Bank of Japan. (2018). Monetary Policy. Financial Markets Department. Retrieved from: https://www.boj.or.jp/en/mopo/measures/mkt_ope/ope_t/index.htm/

Chen, J. (2018, Aug 4). Over-The-Counter – OTC. Investopedia. Retrieved from: https://www.investopedia.com/terms/o/otc.asp

Chen, J. (2018, Feb 14). Flat Yield Curve. Investopedia. Retrieved from: https://www.investopedia.com/terms/f/flatyieldcurve.asp

Chen, J. (2018, Nov 15). Yield to Maturity (YTM). Investopedia. Retrieved from: https://www.investopedia.com/terms/y/yieldtomaturity.asp

Chen, J. (2018, Dec 14). Inverted Yield Curve. Investopedia. Retrieved from: https://www.investopedia.com/terms/i/invertedyieldcurve.asp

Coppola, F. (2018). Japan’s Lowflation Problem. Forbes. Retrieved from: https://www.forbes.com/sites/francescoppola/2018/07/31/japans-lowflation-problem/#28c009f63d64

Dye, J., and Wigglesworth, R. (2018). US 10-year bond yield hits 3% ahead of Fed decision. Financial Times. [Online] August 1. Retrieved from: https://www.ft.com/content/7d440504-9588-11e8-b747-fb1e803ee64e

Famiglietti, M., and Garriga, C. (2018, Oct 11). The FRED Blog: The Data behind the fear of yield curve inversions. The Federal Reserve Bank of St. Louis. Retrieved from: https://fredblog.stlouisfed.org/2018/10/the-data-behind-the-fear-of-yield-curve-inversions/

Fujiki, H. and Tomura, H. (2017). Fiscal cost to exit quantitative easing: the case of Japan. Japan and the World Economy. 42, pp.1-11. 

Investopedia. (2018). Bond Yield. Retrieved from: https://www.investopedia.com/terms/b/bond-yield.asp

Kihara, L. (2018, 25 September). BOJ’s Kuroda highlights need to look at downside of easy policy. Reuters. Retrieved from: https://www.reuters.com/article/us-japan-economy-boj/bojs-kuroda-highlights-need-to-look-at-downside-of-easy-policy-idUSKCN1M50K0

Krugman, R.P. (1998). It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap. Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol.29 (2), pp.137-206.

Monfort, J. (2018, August 08). Japanese Yen Rises After Wage data Surprise and BOJ Tightening Rumours Drive Outlook. PoundSteling Live. Retrieved from:

Morah, C. (2018). Why are most bonds traded on the secondary market “over the counter”? Investopedia. Retrieved from: https://www.investopedia.com/ask/answers/09/bond-over-the-counter.asp

Reid, H. (2018). BoJ easing talk sends bond yields up. Reuters. Retrieved from: https://www.reuters.com/article/global-markets/global-markets-boj-easing-talk-sends-bond-yields-up-idUSL5N1UJ2FY

Rennison, J., and Wigglesworth, R. (2018, July 25). Flattening yield curve stirs US recession fears. Financial Times. Retrieved from: https://www.reuters.com/article/us-global-markets/bond-yields-rise-on-boj-easing-talk-while-stocks-slide-idUSKBN1KD01E&nbsp;

Shirai, S. (2018). Mission Incomplete: Reflating Japan’s Economy. 2nd edition. Asian Development Bank Institute. 

U.S. DEPARTMENT OF THE TREASURY. (2018). Resource Center: Daily Treasury Yield Curve Rates. Retrieved from: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

Trading Economics. (2018) Japan General Government Gross Debt to GDP. Retrieved from: https://tradingeconomics.com/japan/government-debt-to-gdp

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