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 yield curve of government bonds is used as a benchmark for things like mortgage rates and bank lending rates.

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 and 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 tried to control the yield curve

When the Bank of Japan decided to introduce negative interest rates in January 2016, 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.

Later that year, 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 buys longer-dated bonds too. This should have the effect of helping 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 would 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*.

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

*Source: Fidelity, 21 September 2016