10 factors that impact the yield curve?
There are a variety of factors that impact the shape of the yield curve. While the relative importance of each of these factors frequently changes, there are 10 factors that have been and will likely continue to be the most influential for years to come.
By gaining an understanding of the forces that shape the yield curve, bond investors can more deftly select bonds that have maturities that perform optimally under different yield curve environments. For example, in an environment where the yield curve flattens, long maturities will outperform short maturities. In such an environment, investors that place a focus on increasing their exposure to the long-end of the yield curve will achieve a greater return on their fixed income investments than if they took a more passive approach and ignored the shape of the yield curve.
Assessing the current and future direction of the yield curve can be simplified by tracking the following 10 factors:
1) Monetary policy and market expectations on future Fed policy: This is perhaps the single most influential factor that shapes the yield curve. This is because the Fed essentially controls one part of the yield curve—the short-end—and their actions have a big bearing on the other—the long-end.
The Fed affects the short-end of the yield curve when they raise of lower the federal-funds rate. The fed-funds rate, of course, is the rate that banks charge each other for overnight loans. The Fed controls this rate by adjusting the amount of money supply available to the banking system. When the Fed wants to raise the fed-funds rate, they reduce the money supply essentially by selling Treasuries to banks and brokerages (thereby forcing banks and brokerages to pay for the bonds and hence, reduce the amount of available cash that they hold). The Fed raises the money supply when they want to lower the fed-funds rate by buying Treasuries from financial institutions.
By tweaking the money supply, the Fed thereby pushes the fed-funds rate up and down. As the fed-funds rate fluctuates, the interest rate on other short-term securities moves in lockstep. This is because financial institutions usually operate on borrowed money to hold inventory of notes and bonds. So, for example, if the fed-funds rate were 6.50%, it would cost financial institutions about that amount to borrow the money that they need to hold an inventory of notes and bonds (that they expect to re-sell to their customers). Therefore, these institutions would generally be unwilling to hold securities yielding less than that because they would have what is called “negative carry.”
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