Yield Curve going flat

Economists consider Yield Curve as an indicator for economic recession and recovery.




Note: The dips are generally followed by recession

What exactly is a yield curve?

Yield curve is the relationship between short-term and long-term interest rates on debt. The long-term interest rates are higher than the short-term rates. This gives the depositors the motivation to invest in govt. bonds for a long period. The assumption is that in longer term the banks and financial institutions would be able to make money based on the difference in short term and long term interest rates.

How do Banks implement this strategy?

Banks borrow money from the depositors and pay them short-term interest rates. On collecting money from multiple depositors, the banks lend this money as long-term loans. The longer maturity period and higher interest rates assures that the banks would be able to pay back the depositors and in the process be able to add some surplus.

What can go wrong?

The first assumption is that there would be a linear relationship between maturity period and the rise in interest rates. If you plot the yields for various govt. funds for different maturity period (3 months, 2 yrs, 3 yrs, 5 years) as on today, you will get the yield curve. The second assumption is that the majority of lenders would not default on the loan. Contrary to the institutions beliefs, the investors (mortgage owners) defaulted and we went into a recession.

Economic Health

The falling curve or inverted yield curve is an indicator for recession. So can we use the same curve for economic recovery?

As on Oct 2009, the yield curve for treasury bonds is transitioning from a steep curve to a flat one.

For current yield results for bonds visit http://finance.yahoo.com/bonds

The interesting part is that when the yield curves are steep, govt. encourages long-term investors to invest in govt. bonds. However, this time around, either the depositors don't have any money or they have yet to gain trust in banking institutions. This can be one reason that can be attributed as to why the yield curve is going flat.

Sources:

Yield Curve : http://en.wikipedia.org/wiki/Yield_curve
Finance: http://finance.yahoo.com