It is not unusual to come across the phrases ‘steepening yield curve’ and ‘flattening yield curve’ in commentaries discussing interest rate securities. Both phrases refer to the change in shape of the yield curve across different maturities. Interest rate securities come with different maturities and yields generally increase incrementally as maturities extend further into the future. Plotting these yields against each other produces a yield curve such as can be seen below.
When long term interest rates (10 years and above) rise more than shorter term rates (three years and below), then the yield curve will steepen. When long term interest rates rise less than shorter term rates then the yield curve will flatten.
So the question, ‘Why does the yield curve steepen?’ is effectively the same as asking, ‘Why have longer term interest rates risen more than shorter term rates?’
From a macroeconomic perspective, higher interest rates in the future are generally seen as a sign of the economy improving: there will be more economic activity in the future with higher profits for corporates and higher prices. In practice, market participants interpret ‘good’ economic data releases to be a sign that the economy is improving and therefore that interest rates will rise in the future. ‘Good’ economic data might include healthy employment figures, rising inflation figures, rising business confidence indicators, improving balance of payments and so on.
What does this mean from an investor’s perspective?
If an investor buys securities to benefit from yield and he believes that interest rates will rise in the longer term, he will not want to buy fixed interest securities with a long tenor unless the yield on offer reflects his expectations of higher rates in the future. As the yield curve steepens, the investor may become increasingly interested in investing for longer. As the yield curve flattens, the investor may look increasingly to invest in short term securities only.
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Paul McNamara is an editor and journalist with over 20 years’ experience. His career includes spells with the Financial Times, Euromoney, BRW Media, Asia-Inc and Banker Middle East. At present he is editor of YieldReport. YieldReport is a digital newsletter that carries comprehensive pricing and commentary on Australian interest rate securities in a monthly and weekly report. Each issue covers bank bills, cash accounts, term deposits, government bonds, semi-government and corporate bonds, hybrids, ETFs, managed funds and more. Click here for a free trial subscription. |
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