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Explained | What the hell is a yield curve, why would anyone want to control it and other annoying questions answered

Several investors and stakeholders actively place bets on the stock market in anticipation of the yield curve controls (YCC) policy. Here is a deep look at its significance and what you should know about it.

August 25, 2020 / 09:34 PM IST

Today, we thought we would address a concept that recent financial news has substantially focused on - ‘yield curves’. More specifically, the Federal Reserve (Fed) - the central bank of US, has been hinting at something called ‘yield curve controls (YCC)’, which has in turn fuelled concerns over the shape and slope of the yield curve. One can, in fact, see various investors and stakeholders actively placing bets on the stock market in anticipation of the YCC policy.

Here’s a quick refresher on what these economic terms mean. The ‘yield’ on a bond refers to the interest rate that one receives when a bond matures. The ‘yield curve’ is a visual representation of the yields on bonds of different maturities. Typically, if expectations about the future are optimistic which literally means that people anticipate higher growth and positive inflation, then, the yield curve will be upward sloping (see figure 1). This indicates that bonds with longer maturities have higher yields than short-term bonds. 

Now what does one mean when they say that the yield curve is steep? From figure 1 it is obvious that the long-term bonds, as can be seen on the steeper red line, have a much higher yield than short-term rates. This difference between the rates is known as the ‘spread’ and a steeper yield curve essentially refers to a larger spread. If investors expect a higher inflation in the future which means that long-term bonds could lose value over time then, investors will hold these bonds only if interest rates are sufficiently high or more precisely if the spread is sufficiently large. 

Figure 1: US Yield curve for bonds of different maturities on Jan 2, 2020 and July 21, 2020, Source: Treasury, US Government Figure 1: US Yield curve for bonds of different maturities on Jan 2, 2020 and July 21, 2020, Source: Treasury, US Government