Yield Curve – The relationship between term to maturity of various

government bonds and the respective yields.

Interest

Rate 7% A

6%

4% C

2%

1%

3M 6M 12M 2Y 5Y 10Y 30Y

Term to Maturity in Years)

A – Upward sloping B – Flat Yield Curve C – Inverted Yield Curve

Shorter end of the yield Curve

Longer end of the yield Curve

Rising Yield Curve –Short-term rates are low and consistently increases over the period and more or
less flatten at the longer end

Steepening yield curve – The short-term rates are very low and long-term rates are high and hence
the spread is higher.

Flat yield curve – The difference between short- and long-term rates are relatively lesser

Inverted yield curve – The short-term rates are higher than long term rates.

These patterns were found during the simulation exercise between 2003 – 2008 (yield curve.com) .
Some of the factors influencing the yield curve
(Also highlighting the 2003-2008) situation:

Monetary Policy: Central bank policy interest rate decision

Generally monetary policy has an impact on the yield curve.

An interest rate increase by the respective central bank (the interest rate for commercial banks to
borrow from the central bank) impacts the shorter end of the yield curve. Shorter end tends to
increase. Longer end might have a lesser impact.; a consistent interest rate increase will start having
impact on the longer end also. (Although it has been seen in some situations, shorter end changes
immediately impact the longer end curve also). Interest rate increase by the central bank may be for
controlling inflation of the economy.

As the interest rate increases, cost of borrowing for both the individuals as well as companies are
expected to increase. This could bring down the marginal loan borrowing and thereby reduction in
the demand and possible inflation control.

The reverse happens, if there is an interest rate cut by the central bank. The yield curve starts
moving down. There was interest rate reduction during early period of 2000 which resulted in
shorter end of the yield being very low.

Fiscal Policy

An expansionary fiscal policy (government spending more) is expected to have a rise in the yield
curve because of an expected rise in the fiscal deficit. The assumption is as follows:

As the fiscal deficit increases, the market expects the government to borrow in a challenging
situation and the expected rate of return (yield or yield to maturity) of the government
bonds starts rising.

On the contrary, if there is a sudden increase in the tax rate (personal or corporate tax rates) the
general impact could be the following:

A sudden increase in tax rate is expected to create a low demand on products (if personal
tax rate) or lower profits (if it is corporate tax rate). This could lead to negative impact on
the companies (At least for a shorter period). There is a chance of investors selling stocks
and buying bonds (for some time – not always necessary), which will result in bond price
increasing and the yield reducing.

Economic growth

Faster economic growth (high growth in short period) is expected to create inflation. Since Inflation
and interest rates are positively correlated, the yield generally starts rising. (2004, 2005 etc)

Portfolio shifts

When there is a major crisis, the general tendency by the financial market participants is to move
away from the risky asset classes (stocks, commodity etc.) to safer government bonds. Hence the
risky asset classes are sold (their prices decrease) and the demand for bonds (especially government
bonds) increases. Bond price increases and the yield falls. (Bond yield and prices are inversely
proportional)
Among the bonds, depending on the magnitude of the crisis, there will be a preference to buy short
term bonds. Hence the short-term bonds prices increase and its respective yield comes down. The
long-term bond might not get impacted immediately. (2008 after the Lehman situation)

A small note on negative Interest rates and Economic Growth

Consistent negative interest rates are not common for various countries except Japan and some of
the European countries (for some time).

However negative or at least very low interest rates and thereby low yields became common for
very many countries, during the year 2020-21 because of the Covid 19 crisis. This could be only for
some time for many countries. (till the economic recovery).

Negative interest rates or very low interest rates, influences an investor not to save/invest money
in bank deposits or bonds for long time as it generates low return or no return. Alternatively, It
compels individuals or companies to borrow and start utilising for consumption or business
expansion respectively. Negative or very low rates have an impact on influence the people from just
saving to spending, thereby promoting economic growth.

However, with the Japan and European experience, there is a general feeling that the reduction in
interest rates (and thereby very low yield) can generate demand up to some level only.

E.g A reduction in interest rates from 3% to 2% may spur demand for some time, may be one more
reduction from 2% to 1.5%. But a consistent reduction from 1.5% to 1%, 0.5% in a short period of
time may not increase the demand in the same way, unless and until some other factor creates
demand (e.g increase in income levels, disposable income etc.)