Yield Curve, Empirical Regularities and Facts

This is originally posted on  Saturday, 9 February 2013 at 12:07

2012 ZB 13a

Briefly describe the empirical regularities related to the yield curve.

A yield curve serves as an indicator of the prevailing economic climate and market sentiments. Hence the empirical regularities related to the yield curve usually arise under specific contexts.

The first empirical regularity involves the observation that interest rates on bonds of different maturities tend to move together over time, which is reflected in the parallel horizontal shifts of the yield curve.

The second empirical regularity involves the observation that when short term interest rates are low, yield curves are more likely to have an upward slope. Conversely when short term interest rates are low, yield curves are likely to slope downwards and be inverted. 

Steep upward sloping yield curves has often preceded economic upturns while strongly inverted yield curves have historically preceded economic depressions. Campbell R. Harvey's 1986 dissertation showed that an inverted yield curve accurately forecasts US recessions.

The third empirical regularity involves the observation that in general, a yield curve is usually upward sloping rather than inverted: the longer the maturity, the higher the yield. It also tend to exhibit diminishing marginal increases- the yield curve flattens out as the Time to Maturity increases. 

2010 ZA 14 

What are the empirical facts a good theory of the term structure of interest rates has to explain?

Mishkin (2001) states that besides explaining the shapes of yield curve, a good theory of interest rates should explain the following empirical observations: 

1. Interest rates on bonds of different maturities move together over time.

2. When short term interest rates are low, yield curves are more likely to have an upward slope; when short term interest rates are low, yield curves are likely to slope downwards and be inverted. 

3. Yield curves almost always slope upwards.

Economists have developed theories to explain the empirical observations about the shape of the yield curve; the three main theories are the Expectations Hypothesis, the Segmented Market theory and the Liquidity Premium theory (Mishkin, 1999). The fourth theory, the Preferred Habitat theory, is closely linked to the Liquidity Premium theory. 

The Expectations Hypothesis explains the first two facts about the yield curve, but not the third. The third fact is explained by the Segmented Market theory, and all the three facts are explained by the Liquidity Premium theory. 

Inverted Yield Curve 

As the economy slows down, the short term interest rates will be higher than long term interest rates because investors expect lower inflation rates in the future. Their required nominal return on long term bonds will therefore be lower. It also reflects poor outlook- yields are expected to fall even further over the longer horizon. Strongly inverted yield curves have historically preceded economic depressions. Campbell R. Harvey's 1986 dissertation showed that an inverted yield curve accurately forecasts US recessions.

On the other hand, throughout the 19th and early 20th century, the US economy experienced trend growth with persistent deflation. During this period of persistent deflation, the yield curve was generally inverted despite an extended period of economic growth. 

In addition, tightening monetary policy to stave off inflationary pressures (disinflation policies) in the economy will contribute to the rise in short term interest rates relative to long term interest rates.

Therefore the inverted yield curve may reflect different realities, depending on the context.