An interest rate curve is one of the most important indicators in financial markets. I will tell how what it is, how to read it, and how to use it to take investment decisions.
Content
- What is an Interest Rate Curve?
- Many Interest Rate Curves
- What does the shape of the Interest Rate Curve tell us?
What is an Interest Rate Curve?
Although very little is said about the interest rate curve when talking about the economy, it is one of the most important indicators available. In this post, we will use the terms interest rate curve and yield curve interchangeably.
An interest rate curve tells us the level of interest rates to borrow and lend money for different time horizons. The interest rate curve will tell us how high interest rates are for those who want to borrow and lend money for only 6 months, 1 year, 5 years, 10 years, 30 years or even longer.
In summary, the interest rate curve tells us the price of money for different time horizons.
It is called interest rate curve because, when we plot it on a chart, it usually looks like a curve.
On the horizontal axis we have time. The further we go to the right, the longer we would have to wait to get our money back.
On the vertical axis we have the corresponding interest rate. It tells the cost of money for loans with different maturities.
Many Interest Rate Curves
There are many interest rate curves in financial markets. They are sometimes called yield curves. The reason is for that is every currency has its own interest rates. And even for the same currency, every major borrow has its own borrowing costs.
For example, the US government yield curve tells us the interest rate level that the US government pays to borrow at different maturities. It also tells us how much money we, as investors, will receive if we lend money to the US government by buying its bonds.
In the Eurozone, a monetary union of many different countries, every country has its own interest rate curve. This adds complexity to the analysis. But remember, lending money to Germany for a year is a lot different than lending money to Italy for 50 years.
These interest rate curves in the Eurozone can also be analyzed to tell the difference in borrowing costs between countries. These differences are known as spreads. And it is a very important piece of information.
If the market is demanding a lot more interest to buy Italian or Spanish bonds than German bonds, investors perceive a high level of risk in those Southern European countries. On the other hand, if interest rates are quite similar, the macroeconomic situation is seen as stable.
It is even possible to construct interest rate curves for supranational, regional, or municipal governments, and big corporations, as long as they issue debt on a regular basis.
For example, companies like AT&T or even Apple have bonds outstanding in different maturities. They all trade at different interest rates, or yield. Hence, it is possible for us to see how much interest AT&T or Apply pay to borrow money at different maturities.
There is not a set number of yield or interest rate curves in the world. Curves can be constructed if we have the necessary information to tell the interest rate costs for someone to borrow money for different time horizons.
What does the shape of the Interest Rate Curve tell us?
As mentioned above, the shape of an interest rate curve can tell us a lot about the macroeconomic situation we find ourselves in. The outlook for economic growth, inflation, and even corporate defaults can be seen by looking at an interest rate curve.
Interest rates are usually higher for longer maturities. This is mainly because there is more risk of high inflation, and because lenders want to be compensated for not being able to use their money for a longer period of time.
An interest rate curve that shows higher interest rates the further we go into the future is seen as healthy. It indicates a positive outlook about the future of the economy, with solid growth and potential for inflation.
However, there are circumstances in which a yield curve may look different, and that tells us a lot about what might happen in the future.
Flat or Inverted Yield Curve
A flat or even inverted yield curve is something less common. A flat interest rate curve is one in which long-term interest rates are very similar to short-term interest rates. For example, 2-year interest rates are at 3% and 30-year interest rates too. It means lenders are not demanding any premium to lending their money for the long term.
In more extreme cases, we can also see an inverted yield curve. This occurs when short-term interest rates are higher than long-term interest rates. For example, 2-year rates are 4% and 30-year rates are 2.5%.
Both flat and inverted yield curves give us the same warning signal. The only difference is that this signal is even stronger when the curve is inverted.
The warning indicated a flat or inverted interest rate curve is that the economy is weak getting weaker. It predicts lower economic growth or even recession, lower inflation or even deflation, and higher default rates. As a result, it also foresees a weaker labor market with higher unemployment.
While central banks like to ignore the warnings given by yield curves, it should be noted that they have historically been a very accurate predictor of what was to come in the economy.
For example, the main interest rate curve in the United States, the US government yield curve, began to flatten and invert in 2006, over two years before the bankruptcy of Lehman Brothers in 2008.
Government officials disregarded the yield curve for a very long time. Eventually, however, the entire banking system came crumbling down and the economic entered the deepest recession since the 1930s.
And what came with that? Lower economic growth, lower inflation, corporate defaults, and higher unemployment. All those things justify lower interest rates. A flat or inverted yield curve, by demanding lower interest rate for longer term bonds, is anticipating that rates will be lower in the future because of a weak economy.
Apart from this anticipation, the lower interest rates for long-term bonds are also seen as an indication that many investors buying these bonds as a hedge. High demand leads to higher bond prices, and higher bond prices to lower interest rates.
They expect many of their equity investments or private sector loans to lose value. In such a scenario, the demand for safe long term government bonds will increase, and these investors will realize a capital gain from these bonds.
As a result, whenever you see a flat or inverted yield curve, you should probably be cautious in your investments.
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