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TREASURY YIELD CURVE:  Current Spot and Forward Curves

There are many types of fixed-income securities and markets. The largest fixed income market results from the U.S. Treasury, borrowing cash from the general investing public. The prices of these fixed-income securities result from trading, and which generates the Treasury yield curve by plotting the implied yield to maturity from the prices of Treasury instruments against the time to maturity.   This yield curve has a direct influence over all economic activity in the US. 

In the charts below the current behavior for the Treasury yield curve is provided for a choice of common compounding conventions.  To apply the yield curve requires answering a few basic questions.   These questions are described below the following chart.  An expalnation of the concepts required to answer these questions is provided in the Textbook link to the left.

 
Working with the Yield Curve

You first need to answer a few basic questions:
1.  What is my problem's time horizon?  In other words which rate is relevant -- 3-months, 5-years or 30-years?
This often depends upon the investment horizon you are working with.  For example, suppose you are applying the Capital Asset Pricing Model (CAPM) to estimate the expected return from a stock.  This requires working with the yield curve and many users choose a rate between 10-years and 30-years to estimate expected returns when using CAPM.
2.  What is my compounding convention?  This could be continuous compounding if you are working with options or it may be discrete.  If discrete how many times am I compounding per year?
3.  Is it important to assess a pure discount rate?  The pure disocunt rate is implied from a Treasury zero coupon bond (i.e., Treasury strips and treasury bills).  The pure discount rate or "Zero" curve is important when working with any valuation problem.
4.  What is the current yield curve telling me about future interest rates?  By backing out the "forward curve" this provides important information about what investors expectations about future rates are.

The above set of charts provide all of the above.  That is, you can see the current Treasury Yield curve depicted in continuous through to annual compounding forms.  You can also see plotted the spot rates, the zero curve rates and the forward rates.  That latter lets you take a look into the future using current market data.  To read more about the above types of questions and concepts you are encouraged to click on Bond Tutor: The Textbook to the left on this screen.

What Drives the Yield Curve?

From the above charts you can see that the yield curve shifts over time.  These shifts are inresponse to changes in expectations about the major fundamental drivers of the yield curve.  That is,

Inflation Expectations

Consumption/Growth Behavior Changes

Federal Reserve Bank Expectations

Inflation Expectations

If consumer prices are expected to increase strongly then the suppliers of capital must be rewarded more for postponing their consumption decisions.  That is, the opportunity cost of consumption must increase and so inflation expectations will have a direct first order impact upon interest rates.  To explore this further see the tab above labelled "Inflation."

Consumption/Growth Expectations

If growth declines and the economy moves into a recession -- how would this influence your decision to consume today?  The answer is likely to be negatively.  Job prospects, bonuses, pay rises are likely to disappear and so major consumption decisions become postponed.  This implies that the suppliers of capital no longer need to be rewarded as much for postponing consumption and thus interest rates will decline.

Federal Reserve Bank Expectations

In the United States, the Federal Reserve has a dual mandate:  To promote stable inflation and to promote maximum employment. In addition, the Federal Reserve is legally permitted to manipulate the US Treasury markets.  As a result, the Federal Reserve Bank manipulates the US Treasury yield curve -- particularly at the short end in an attempt to implement it's dual manadate.

When the Federal Reserve Bank is trying to promote consumption and growth it lowers interest rates by agressively buying and pushing prices up.  Given the inverse relationship between prices and the yield to maturity this implies that interest rates fall.  If it is trying to dampen consumption/growth the Federal Reserve Bank does the opposite and starts to aggresively sell Treasury instruments to push prices down.  This results in shifting interest rates up.