The Yield Curve: Top 3 Theories to Know
In the world of interest rates, the yield curve is a fundamental object to understand, alongside bonds and their pricing. It shows interest rates/yields at different maturities/tenors. Since it is a curve, the natural question arises – what does it usually look like (its shape) and why? Today, we will discuss the top 3 theories about the yield curve that can help to shed some light.
The Typical Shape of the Yield Curve
The usual shape of the yield curve is upward-sloping. The farther out the maturity/tenor, the higher the yield/interest rate. See the stylized yield curve below.
The key question is: why does it look this way?
Three popular theories can help to explain this upward-sloping shape – let’s take a look.
Yield Curve Theories
1) Pure Expectations Theory
The Pure Expectations Theory says that the current shape of the yield curve only reflects the market’s future short-term interest rate expectations. Basically, this means that future short-term rate expectations are linked to the current observed rates. The yield curve is upward-sloping because the market generally expects future short-term rates to rise (growing economy) and hence, demands more interest for a longer maturity.
For example, if the current 1-year rate is 4% and the future 1-year rate is expected to rise, then the 2-year rate today must be higher than 4% to compensate the investor for locking up his money today for 2 years.
Vice versa, if the current 3-year rate is 7% while the 1-year rate is 4%, that means investors expect the 2-year rate in 1 year’s time to be higher than 7%. They demand this higher rate to ensure that they don’t lose out by locking up their money for 3 years now, rather than investing it for 1 year now and THEN re-investing for 2 years at the prevailing rate.
2) Liquidity Preference Theory
The Liquidity Preference Theory says that investors prefer money (liquidity) today rather than in the future. Intuitively, this makes a lot of sense. Would you prefer a dollar today or a dollar in a year’s time? Most people prefer a dollar today. Therefore, the longer you lock up your money in your bank account (say a fixed deposit), the more return you’ll expect to get on that money.
For example, if investors had $100 to invest and may choose to invest for 1 year or 30 years, they will demand a higher rate for the 30-year tenor. This is because staying invested for 30 years implies a loss of opportunity to use this money along the way.
3) Market Segmentation Theory
The market segmentation theory says that different segments of the bond market are keen on different parts of the yield curve. They have different needs, motivations, and behaviors that will together influence the shape of the curve. Broadly speaking, one may divide the yield curve into three segments: short-term, medium-term, and long-term.
For example, long-term bond investors may include pension funds and insurance companies that have long-term liabilities and seek matching long-term assets. Short-term bond investors, on the other hand, may include money-market funds and corporations looking for safe and predictable returns. Medium-term bond investors may include asset managers and mutual funds. Read up more about key players in the bond market here.
Unlike the earlier theories, there isn’t a straightforward explanation from the Market Segmentation Theory on why the yield curve slopes upward.
Using the Theories as Lenses
Apart from the shape of the yield curve, these theories may act as different lenses to analyze yield curve movements.
For example, per the market segmentation theory, we know that pension funds and insurance companies participate in the long-term rates market. if they have already hedged their liabilities, then new long-term bond issuances are less appealing. Therefore, long-term rates should rise given the higher supply and lower demand in the market. Another example is if the yield curve is inverted, investors expect future rates to be cut (Pure Expectations Theory). This suggests accompanying economic weakness and possibly a fall in equity prices.
Ultimately, it’s all about supply and demand in the market that affects yields at different maturities. This determines the shape of the curve.
Based on the above theories, how do you think the yield curve will look tomorrow?
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