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How to Interpret Yield Curve

Yield curve reflects the interest rate environment in an economy and the change in yield curve reflects central bank's policy initiatives as well as liquidity situation (available investable money) in the financial system and government's borrowing needs. 

Animated Line Chart with Traces

Bangladesh Treasury Yield Curve (%)

Source: Bangladesh Bank (based on monthly weighted average yield published by Bangladesh Bank)

It is an important concept to learn to be able to understand the outlook of the economy and assess your investment decision. 

A yield curve is a line that plots yields, or interest rates, of bonds of equal risk but differing maturities.

For instance, treasury yield curve plots the yields or interest rates of treasury bonds (instrument issued by government to borrow funds from institutions and individuals) of different maturities.

On the X axis, the graph shows the maturities of bonds and on the Y axis, it shows the yield on bonds (how much return you can expect if you buy the bond now).

Yield Curve by Md Nazmus Sakib

Generally, a yield curve is upward sloping. With extension of maturities, yield on bond in a given point in time increases to compensate for the maturity risk. 

In special occasion, it can become downward sloping and the curve becomes inverted.

When we refer to yield curve, we generally refer to treasury yield curve. Interest rate in the economy usually follows the trend of treasury yield curve.

The yield curve generally represents the monetary policy actions taken by central bank and conditions of money supply.

When the rates are low (relative to historical average), it is assumed that the monetary policy is expansionary and is trying to support growth of the economy.

When the rates are high (relative to historical average), it is assumed that the monetary policy is contractionary and is trying to contain inflation in the economy.

Most of the time, monetary policy actions are taken to tackle short term issues like inflationary pressure or slowdown in economic activity.

And to tackle the short term issues, the central bank usually also targets the short term rates to influence the economy.

Central bank tries to change interest rates to influence the economy.

But the change in rates of bonds is not linear. Short term bonds can rise or fall higher or lower than the long term bonds and vice versa. Such change indicates different outlook of the economy.

When short term rates fall greater than the long term rates, it is termed as bullish steepening.

It's bullish, because when rates fall, it suggests that monetary policy is designed to stimulate the economy. And as you can see, the curve steepens.

On the other hand, when short term rates rise greater than the long term rates, it is termed as bearish flattening.

It's bearish, because when rates rise, it suggests that monetary policy is designed to tighten the economy. And as you can see, the curve flattens.

The opposites can also happen when long term rates rise or fall greater than short term rates.

The curve can also invert. When long term bond yield is lower than short term bonds, it is called inverted yield curve.

The inverted yield curve is often considered a predictor of a recession. The curve doesn't cause the recession. It is assumed that, when investors fear a recession, they usually take their funds to longer term bonds and avoid short term bonds to lock in the current yield before it falls further. Because, when recession happens, central banks lower the rates to stimulate economy. The increased fund flow to longer term bonds cause the yield to fall faster than short term bonds.

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