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What is a yield curve – and why should you care?

Yield curves have historically only really been a hot topic around the desks of bond fund managers. They tend to hold little interest (pardon the pun) for the rest of the world's population. But investors may want to start paying a little more attention.

Why? Because the Bank of Japan is now trying to control the Japanese yield curve as part of its monetary easing strategy.

The yield curve explained

The yield curve is basically a line graph that plots the interest rates of similar quality bonds with different maturity dates. The yield curve of government bonds (because they are considered to be risk-free) is used as a benchmark for things like mortgage rates and bank lending rates.

The shape of the yield curve gives you an idea of the direction of future interest rates and the health of the economy. A 'normal' shape would be one where bonds with a longer time to maturity have a higher interest rate than those that are close to maturity (so the line goes upwards). This is because investors in a bond due to mature in, say, three months can be pretty certain the money they get back will be worth what it is today. There is less certainty they will get back the same amount in 10 years' time, therefore investors might expect a higher yield to compensate for that risk.

If the line is going the opposite way it can be seen as a sign of recession. This is because investors expect interest rates to fall as the central banks look to promote the growth of the economy rather than trying to control inflation.

Why the Bank of Japan wants to control the yield curve

When the Bank of Japan decided to introduce negative interest rates in January, it hoped it would boost economic activity by making it cheaper for businesses and consumers to borrow money. Instead, bank margins got squeezed, their profits dropped and shares slumped. The yield curve became 'flat' in shape.

At its meeting yesterday, the Bank of Japan decided to maintain negative interest rates but surprised investors by unveiling new monetary policy tools, including placing a cap on its 10-year government bond yields of 0%. This means that the government is promising to buy any bonds offered for sale at that price.

Instead of just buying short-dated bonds as part of its quantitative easing programme, the government will buy longer-dated bonds too. This should help the yield curve to 'steepen' and make it easier for banks to make a profit and also insurance companies, which tend to hold very long-dated government bonds and have been suffering due to the falling yields.

The Japanese equity market responded positively to the announcement, with the TOPIX rising 2.7% in local currency terms*.

Does this change our view on Japan as an investment choice?

Not really. The Bank of Japan has no choice but to carry on down the road of trying to stimulate the economy. Broadly, we think Abe is doing a good job and, with his 'super-majority', he has the power to finally make significant reforms. It's going to be far from easy though and there are likely to be as many ups as downs.

Read more: Is now a good time to buy in a Japan fund?

Research Japanese equity funds

*Source: Fidelity, 21 September 2016

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are opinions only and do not constitute financial advice.