Stocks & Commodities V. 31:12 (12-19): Understanding The Yield Curve, Part 2 by Giorgos E. Siligardos, Ph.D.

Stocks & Commodities V. 31:12 (12-19): Understanding The Yield Curve, Part 2 by Giorgos E. Siligardos, Ph.D.
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Understanding The Yield Curve, Part 2 by Giorgos E. Siligardos, Ph.D.

The World Of Yields

Last month in part 1, we presented the basics of yield curve analysis. Here, we review its historical performance in various countries through the use of yield spread indicators.

What constitutes a positive or negative yield curve? The strict definition is that a yield curve (YC) is positive when all of its parts are rising; itís negative when all of its parts are falling; and itís flat when itís a straight horizontal line. Oftentimes, however, the YC is close to being considered positive or negative even though parts of it ó usually the far left and/or far right ó do not conform to the strict definition (Figure 1). Further, it is almost impossible for the yields of all maturities to be exactly the same, which means that if you go by the strict definition of a flat curve, realistically you will probably never find a flat curve. From studying past performance of yield curves, I have found that these loosely positive and negative curves have similar implications for the economy as the outright positive and negative ones do. This is why it is necessary to be more flexible in defining the YC. The simplest way to do this is through yield spread indicators.

Yield spread indicators

Academics usually study differences (known as ďspreadsĒ) between longand short-term government debt securities (GDS) as surrogates of the YC shape in order to see how well they relate to business and economic cycles. Practitioners study these spreads to help them make better investment decisions in the stock market (Figure 2). The most popular spread (and considered the best by many analysts) is the three-month/10- year spread, which is computed by subtracting the yield of GDS that mature in three months from the yield of GDS that mature in 10 years. When the spread is positive, the YC is considered positive and when the spread is negative, the YC is considered negative. Other similar short-term/ long-term spreads are believed to underperform the three-month/10- year spread, but not by much.

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