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Understanding The Yield Curve

The yield curve is a graph between Treasury yield and maturity. It indicates the relationship between the interest rate and the time to maturity of a Treasury bond. The US Treasury notes are issued with different maturities, from few days to thirty years, and the relationship between these rates can be studied through a yield curve. The curve depicts the credit risk that an investor is ready to take for a particular maturity of the bond. The yield curve provides a picture of current state of the economy, and the expected outcomes in the future. Fund managers, traders, economist and analysts keep a close watch on the fluctuation in the curve. It helps them in identifying new opportunities and reviewing their existing investments. The yield curves are also used for understanding investors' sentiments about the health of the US economy and for making policy decisions by the government. It also reflects the current monetary policy of the government.

There are three typical shapes for a treasury curve - normal (upward sloping), flat and inverted (downward sloping). Under normal circumstances the curve would be upward sloping, indicating requirement of extra premium for taking prolonged risk. However, whenever there is a flattening or inversion of yield curve, it requires some explanation. Recently, the US, under its long term easing policy, executed Operation Twist. Under this program, the FED purchased long-dates treasuries and simultaneously sold some of the short-dated issues. This was done to reduce the long term interest rates so that mortgages become affordable, and the housing sector remains healthy.

The slope of the yield curve is basically driven by two factors - the monetary policy of the Federal Reserve, as it raises or lowers short-term interest rates, and the buying and selling of the US treasury bonds. The short end of the curve is usually directly impacted by the interest rate policies of the Federal Reserve. However, the long end is mostly driven by the demand of investors such as pension fund managers.

The slope of the treasury yield curve is considered a leading economic indicator. The inversion of the curve is considered as a precursor of a recession. The spread between long and short term interest rates contains crucial information that foretells the overall health of the economy. During an inverted yield curve, the short term rates are higher than long term rates. The phenomenon was observed in 2006, when the yields on 10-year Treasury fell below yields on 3-month Treasury bill. An inverted yield curve indicates an imminent slowdown in economic activities and an indicator that FED will have to lower the interest rate in order to stimulate the economy. In the current context, by keeping the short term rates near zero, the FED has ruled out any possibility of yield inversion.