KULLIYYAH OF ECONOMICS AND MANAGEMENT SCIENCES

FINANCIAL ECONOMICS

(ECON 6810)

ASSIGNMENT I:

ANALYSIS OF THE YIELD CURVE

PREPARED BY:
IYLIA HANIS BT. HUSIN
G0916656

SUBMITTED TO:
ASSOC. PROF. DR. SALINA HJ. KASSIM

SEMESTER II, 2010/2011

1
Introduction
A yield curve is a graphical illustration of where interest rates are today. There is not one
universal interest rate that caters to everyone investment’s appetites. The interest rate is
different for those who want to invest now for the next three months, six months, and so
on out to thirty years and longer. The yield curve shows the rate of return that can be
locked in now for various terms into the future.

Types of yield curve

1. Normal yield curve
• The normal yield curve is supposed to be a positive yield curve. In case of
the normal yield curve the debt instruments that are being compared are
equal with regard to quality of credit. However, the debt instruments that
have a longer term period produce better yields than the debt instruments
that have a shorter term period.

2. Flat yield curve

• As far as a flat yield curve is concerned the yields of the debt instruments
with short term periods and the yield of debt instruments with long term
periods are almost the same. The flat yield curve could be observed when
there is a changeover between an inverted yield curve and a normal yield
curve.

3. Inverted yield curve

• In the instance of an inverted yield curve, the yield of a debt instrument
having a long term period has a lesser amount of yield compared to a debt
instrument that has a same credit quality but comes with a shorter term
period.
4. Steep yield curve
• The steep yield curve is a type of yield curve. The steep yield curve is
normally observed at the following periods in an economy:
o Post recession period
o Prior to economic enlargement

2
Analysis of the yield curve : Malaysia.
For better understanding of the information content in the yield curve, a few figures were
collected from The Central Bank of Malaysia’s website (www.bnm.gov.my). Based on
those figures, the yield curve was structured.

The chart shows the spread between (average) interbank rates for overnight, 1 week and 1
month money. While the spread between overnight and 1 month money was flat
throughout 2008, the spreads between overnight and 1 week against 1 month money both
turned negative in November and January 2009. In other words, money is cheaper in the
future than it is right now, or equivalently demand for money now is higher than demand
for money in the future. From a term structure perspective, the yield curve (the ranking of
interest rates based on maturities), which would normally be upward sloping to reflect
risk and inflation expectations, has inverted. The interpretation for a yield curve that gets
flatter can vary depending on the situation, but generally follow along these lines:
1. The market is pricing in an interest rate cut

3
 2. The market is expecting deflation/reduced inflation
3. The market for whatever reason desires short term liquidity

An inversion of the yield curve is more serious, and is usually taken to represent a
recession signal. Forthrightly, this indication is based on just a couple of data points.
However, given the other data, it is fitting enough to take this as weak confirmation that
Malaysia is in a technical recession during 2009.

Hypothetically, an inverted yield curve has been viewed as an indicator of a pending

economic recession. When short-term interest rates exceed long-term rates, market
sentiment suggests that the long-term outlook is poor and that the yields offered by long-
term fixed income will continue to fall. However, the converse is not necessarily true;
not every inverted yield curve has resulted in a recession. On the other hand, recessions
have followed inverted yield curves often enough that a yield curve inversion is seen by
many analysts as an important leading indicator of the possibility of a severe economic
slowdown.

Impacts of the inverted yield curve

1. Savers
• The inverted yield curve gives savers a rare occasion to get rewarded for
keeping their investments short. Some of the best deals around for savers
are Certificate of Deposits (CDs) that mature in one year or less. In
contrast, it's nearly impossible to find similar rates on CDs with longer
maturities. The usual situation, in which savers can lock in higher rates by
tying up their money for longer periods of time, doesn't hold true when the
yield curve is inverted.
2. Consumers
• In addition to its impact on savers, an inverted yield curve also has an
impact on consumers. For example, , homebuyers financing their
properties with adjustable-rate mortgages (ARMs) have interest-rate
schedules that are periodically updated based on short-term interest rates.

4
 When short-term rates are higher than long-term rates, payments on
ARMs tend to rise. When this occurs, fixed-rate loans may be more
attractive than adjustable-rate loans.
• Lines of credit are affected in a similar manner. In both cases, consumers
must dedicate a larger portion of their incomes toward servicing existing
debt. This reduces expendable income and has a negative effect on the
economy as a whole.

3. Fixed-Income Investors
• A yield curve inversion has the greatest impact on fixed-income investors.
In normal state of affairs, long-term investments have higher yields;
because investors are risking their money for longer periods of time, they
are rewarded with higher payouts. An inverted curve eliminates the risk
premium for long-term investments, allowing investors to get better
returns with short-term investments. When the spread between Malaysian
Treasuries (a risk-free investment) and higher-risk corporate alternatives is
at historical lows, it is often an easy decision to invest in lower-risk
vehicles.
• In such cases, purchasing a Treasury-backed security provides a yield
similar to the yield on junk bonds, corporate bonds, real estate investment
trusts and other debt instruments, but without the risk inherent in these
vehicles. Money market funds and certificates of deposit (CDs) may also
be attractive - particularly when a one-year CD is paying yields
comparable to those on a 10-year Treasury bond.

4. Equity Investor
• When the yield curve becomes inverted, profit margins fall for companies
that borrow cash at short-term rates and lend at long-term rates, such as
community banks. Likewise, hedge funds are often forced to take on
increased risk in order to achieve their desired level of returns.

5
 • Despite their consequences for some parties, yield curve inversions tend to
have less impact on consumer staples and healthcare firms, which are not
interest-rate dependent. This relationship becomes clear when an inverted
yield curve precedes a recession. When this occurs, investors tend to turn
to defensive stocks, such as those in the food, oil and tobacco industries,
which are often less affected by downturns in the economy.
5. Policy makers
• The inversion of the yield curve will affect the decision making made by
the policy makers, especially the government. In order to curb the
recession, the reduction of income taxes (fiscal policy tool) can cause
unemployment to decrease and provide an optimistic financial strategy for
majority of the employed workforce. It also increases productivity and
healthy business ethics, both of which are beneficial for businesses,
employers, and overall commerce.
• Apart from that, decreasing interest rates (monetary policy tool) can assist
to control a recession in the economy. By decreasing such rates, strength
to sustain economic growth is forseeable. Furthermore, when the
government aptly continues to decrease interest rates and attempts to
decelerate an obvious decline in a specific market or recover from a
recession toward economic stability, the demand for lending and credit
increases.