The Yield Curve Model
Helps to predict future economic growth, inflation, and recessions
The yield curve model provides one of the most powerful predictors of future economic growth, inflation, and recessions.
The yield curve is constructed by graphing bond yields (as a percentage rate of return) on the vertical axis against the time to maturity of the bond (in years) on the horizontal axis.
It shows the various percentage yields that are currently being offered on bonds of different maturities and enables investors to visually compare the yields offered by short-term, medium-term and long-term bonds.
The economic position of countries and companies using their particular currency is the most important factor in determining the composition of their yield curve. Internationally there is no single yield curve.
Yield curves are calculated and published by a variety of financial institutions around the world. In the USA, this includes The Wall Street Journal and the Federal Reserve.
The Usefulness of the Yield Curve
The slope of the curve can be positive (trending up),flat (horizontal), or negative (trending down). Each of these scenarios, when currently displayed by the yield curve, provides future important economic information.
In general, when the yield curve is positive (upward slope), this indicates that investors require a higher rate of return (yield) for taking the added risk of lending money for a longer period of time.
Many economists also believe that a steep positive curve (upward slope) indicates that investors expect strong future economic growth. This implies higher future inflation, and higher interest rates.
Since historically the yield curve has usually been positive, a positive yield curve is referred to as the normal yield curve.
A sharply inverted yield curve (downward slope) means investors expect sluggish economic growth. This implies lower inflation and lower interest rates.
A flat (horizontal) yield curve generally indicates that investors are unsure about future economic growth and inflation.
The yield curve model has important implications for value investors when considering future asset allocations, as a positively-sloped yield curve is often a predictor of inflationary growth, and an inverted yield curve is often a sign of an oncoming recession.
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