Stocks & Commodities V. 31:11 (10–17): Understanding The Yield Curve, Part 1 by Giorgos E. Siligardos, PhD

Understanding The Yield Curve, Part 1 by Giorgos E. Siligardos, PhD

The Shape Of Things To Come

Understanding The Yield Curve Part 1

In this two-part series, you’ll get a comprehensive review of yield curve analysis and how it can be applied to making decisions in the stock market. In this first part, we’ll look at basic theory as well as some guidelines for how discretionary investors can use it to gauge the investing landscape.

Understanding macro perspectives can provide some added insight into your analysis. I touched on this idea in my August 2012 Stocks & Commodities article “Applying The Sector Rotation Model,” in which I introduced a simple indicator that can help quantify the flow of money between expansionary and recessionary stock market sectors. Quantifying the money flow will uncover the macro investors’ actions and projections about the entire stock market. In this article, I will focus on another interesting and useful analysis tool, directly from the arsenal of macroeconomics — the yield curve.

In this first part, I will outline the basic theory behind the yield curve and explain why it’s important for you to keep an eye on it for your long-term analyses. I will also discuss basic usage guidelines for discretionary investors.

What is the yield curve?

Throughout this article, the term yield curve (YC) will refer to a curve created using the annualized yields-to-maturity (that is, the annualized interest rates paid when you use compound interest) of various government debt securities (GDS) of the same country across all possible maturities in a yield-maturity chart. Theoretically, the YC can take any shape, but it usually manifests itself in one of three varieties: positive, flat, or negative (see Figure 1).