Home > fixed income, interest rates, macro economics > Yield Curve Snapshot & Steepness (term spread) – Canadian Edition

Yield Curve Snapshot & Steepness (term spread) – Canadian Edition

As pointed by CMT, the 5-year bond yield hit a 17-month low…here is s snapshot of the yield curve now vs 3 months ago.

The following chart is rather technical and needs a slightly deeper understanding… I will try to simplify… the steepness (also called term spread) of a yield curve is measured by the difference between the longer term bonds and the shorter term bonds. Traditionally I have seen two measures:

  1. difference in yield between the 30-year bonds and 90-day treasury bills (green chart)
  2. difference in yield between the 10-year and 2-year bonds (blue chart).

For both charts below:

  • This difference hit a multi-decade high in Spring 2009.
  • The higher the difference, the steeper the yield curve (above chart).

Source: Bank of Canada

Source: Bank of Canada

What does a steep yield curve mean?

Paul Krugman provides the best explanation:

to a first approximation you can think of the long term rate as reflecting an average of expected future short-term rates. Short-term rates, in turn, tend to reflect the state of the economy: if the economy improves, the Fed will raise short-term rates, if the economy worsens, the Fed will cut. So long-term rates can be either above or below short rates.

Except that now they can’t. If the economy improves, short rates will rise; but if it worsens, well, they’re already zero (0.25%), so there’s nowhere to go but up. This implies that there has to be a positive term spread.

Until July 2010, short rates in US and Canada were 0.25%. Bank of Canada has since increased short-term rates by 0.75% to 1.00% which is why the sharp drop-off in the term spread or in other words yield curve flattening. Not only that, the long-term rates have also decreased slightly (see figure 1) which will decrease the term spread.

Now, this spread could be fairly small if people expected the economy to remain in the dumps for a long time; see Japan. What the large spread now tells us is that the US (& Canadian) economy is in the dumps now, but that investors see a reasonably good chance of a strong recovery in the not-too-distant future. That’s good news, not bad news.

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