Primer: yield curve
Since housing’s price is intimately related to the cost of capital, policymakers and financial analysts frequently reference the yield curve –
– a simple graphic representation of the relationship between interest rate and loan term.
Consider a two-dimensional graph:
- The horizontal axis is loan maturity, starting with very short intervals (one week, or even overnight) at the left and long periods (ten years, twenty years, or more) on the right.
- The vertical axis is interest rate.
Each point on the graph represents an interest rate and a term for securities of similar quality (e.g. Treasury bills). These points should lie on a continuum something like this:
Now, the longer one projects, the more risks one runs: things that are certain to happen tomorrow become progressively less certain as time increases. Since markets treat uncertainty as risk, and risk as a principal driver of yield, one would thus expect that, all other things being equal:
Longer-term instruments should have higher interest rates
If you graph this on our grid, you would get a rising line that gradually flattens out — a yield curve. When it does rise, it’s called a positive yield curve. And that’s what you see in the diagram above, a very typical yield curve.
The yield curve fluctuates as investors and speculators in bonds and other fixed-rate instruments buy and sell them:
Here’s another one, showing how short-term rates have risen over the last year, while long-term have held constant.
Since these are purely hard debt instruments, their yield — the sole metric by which they are valued — rises and falls with expectations of future interest rates. A fantastic little applet showing the yield curve moving over time can be found here; click “animate.” (More on why the yield curve moves.)
In the long run, interest rates and inflation march in parallel, imperfectly but permanently yoked —
“Which one of us is inflation, and which interest rates?”
– so not only is the yield curve important in itself (it’s the supermarket for hard debt!), it is also a real-time referendum on fiscal policies.
In rare cases (e.g. October, 2001), there can be a negative yield curve, where short-term rates are higher than long-term:
October, 2001: flying upside down?
A negative yield curve is akin to a forecast of stormy weather now clearing, a vote of confidence by financial markets that current troubles will pass away.
For more, see this bank primer, or Kiplinger’s primer on the yield curve.
Congressional staff received orientation ….
