Avatar of admin

by

The Yield Curve Accordion Theory

December 26, 2017 in Economics

By Hal Snarr

accordion.PNG

By: Hal Snarr

The yield curve (a plot of interest rates versus the maturities of securities of equal credit quality) is a handy economic and investment tool. It generally slopes upward because investors expect higher returns when their money is tied up for long periods. When the economy is growing robustly, it tends to steepen as more firms break ground on long-term investment projects. For example, firms may decide to build new factories when the economy is rosy. Since these projects take years to complete, firms issue long-term bonds to finance the construction. This increases the supply of long-term bonds along downward-sloping demand, which pushes long-term bond prices down and yields up. The black dots along the black line in the figure below gives the 2004 yield curve. It slopes upward because a robust recovery was underway.

Yield curves flatten out when investors believe a recession is looming. This results from the demand for long-term bonds rising as investor confidence wanes. As demand shifts out along upward sloping supply, long-term bond prices rise and yields fall. On the other end of the yield curve, short-term bond rates rise. This is a result of investors demanding fewer short-term securities and more long-term securities. In response, suppliers of short-term securities lower prices to attract investors. The black dots along the red line in the above figure gives the 2007 yield curve. It is flat because the Great Recession of 2008 and 2009 was just around the bend.

The red points in the above figure correspond to the federal funds rate. In 2004, the Fed had set it near 1% for about a year to stimulate the economy out of the 2001 recession. After it kept rates too low for too long, it moved it up to 5% in 2007. As it did this, the yield on the 10-year (120-month) treasury was mostly unaffected. The other treasury yields were all pushed up toward the 10-year yield. The figure implies that the Fed has less and less control over treasury yields as maturity increases.

I call the three-dimensional diagram below the Yield Curve Accordion. The red line is the federal funds rate through time. It has a zero maturity. The gray curves are the yields of various treasuries through time. As the gray darkens, the maturity gets further into the future and your eyes go deeper into the figure. For the year 2004, walking up the …read more

Source: MISES INSTITUTE

Leave a reply

You must be logged in to post a comment.