Consider the Yield Curve

One of my favourite tools is that of the Yield Curve, in the US they look at the Treasury Curve and the TED (Treasury/EuroDollar), in Ireland we use the Euribor, and what the curve tells us is the interbank cost of borrowing money, or I should say that is what it represents because it can actually tell so much more. It is a market mechanism that gives an indication of what the belief is in the market towards inflation, interest rates and cost of funding, this isn’t opinion, it is derived from real money flowing around the world and that is why I like it, the Yield Curve doesn’t lie.

So we’ll take a look at what has been happening in the last month.

We see something interesting here, the short term expectation is that rates will remain low, in fact, with deflation still a fear the short-term working money (banks generally run off the 3 month) is getting cheaper of late. The divergence occurs after the 12 month mark, so essentially in a year the change in expectation in the last month is that rates will start to go up by more than what was expected in December, that is where the blue (jan 2010) line breaks away from the purple (dec 09′) one.

What does that indicate? For a start it means that for the next 12 months nobody is overly concerned about a rate hike, we keep hearing it in the press but in the market there is nothing within the next 12 months that spells that out, if there was (and it’s not to say that things can’t or don’t change – quite rapidly at times) you’d see a much steeper curve arising. The other thing we can take from it is that between the 12 month and 2 year mark a rate hike is expected, part of the increase in price at that point is uncertainty, the longer you look out the more uncertain it gets, but the basics of it are that rates will rise at some point after a year from now.

Month to month trends are not the most telling, we can get a clearer picture if we compare several months – not for a secular image but for a cyclical expectation, so here is a chart showing mid Q3 to Q4 and the start of Q1.

What we can see is that in general, the fear of inflation or costing of it into the market, has dropped since August 2009. There has been some consolidation ever since then,you will see that again, they all have a similar expectation up to the 12 month outlook then the expectation changes. November to December saw expectations drop on prices further out, but since then (with fear of ECB reductions in liquidity provision) it rose higher in January 2010.

Oddly, this curve and the steepening of it is good news for banks, they can borrow very cheap on the short term and get a higher rate of return in Bonds (note: lending is likely to reduce because the risk free rate is better), or they can use that steep end to price out higher fixed rates and then go to the swap market.

One way or another, the big question seems to be pegged (recently) to the one year mark, I think that we may be surprised in 2010 by the ECB not increasing rates or doing so only enough to placate the Germans and French (c. 25 basis points).

On the deposit side it means that you can expect banks to drop the rates they are willing to pay depositors, other than banks which are cash hungry, and what many of them will do is offer out a rate then go to the risk free market (sov. bonds) and place it there, in any case, the short term outlook isn’t one where you can expect a credit multiplier, having said that, if and when that comes it may turn out to be pretty impressive.

I hope you can see now why we watch the yield curve so closely! It is a fairly decent compass when you take the time to look at it and compare it over time, I just hope you haven’t already fallen asleep at this stage!


  1. Conor

    another great article on interpreting the yield curve and taking an analytical approach to making mortgage decisions. So do you still think that locking in your mortgage for the long term is the way to go?

  2. Hi Conor,

    I think that it boils down to where your breaking point is, if (for instance) you were to say ‘I did the figures, and if rates go to 6% I’m doomed’ then yes, lock in – pay the premium for doing so in the near term, if not though and you feel you can ride the curve then enjoy the gain you have in the here and now.

    It’s probably the hardest question to ask me! Because on one hand you have to make an inflation call but on the other you have to make a personal decision and only time will tell, my feeling is that the long term fixed rate holders will be glad of their choice in the long term, and the short term tracker/variable thinkers will be glad in the short term – might sound silly but I think that synopsis will hold true.

    One thing variable rate holders should be well aware of is that margins are almost certain to increase this year even if the ECB don’t do anything.
    thanks for dropping by!

  3. Excellent and informative article Karl. As a typical bar stool economist I think that the Interest rate debate is going to be one of the big talking points in the meeeja as the year progresses.

    The “shall I fix or ride it out on variable” debate will have lots of people losing sleep and threatens any kind of economic recovery in debt burdened Ireland.

    As you’ve said countless times before – if you’re risk averse move to fixed now and pay the premium for your piece of mind.

    Personally I can’t see rates going up beyond 1% in the next 24 months – although as you’ve said that could change quickly if inflation takes hold with all this government stimuli across Europe.

    A lot of people are struggling already and that’s with interest rates at all time lows – doesn’t bear thinking about what will happen if inflation gets out of hand and rates go up by anything more than 2-3%

  4. Anne

    Hi Karl.

    I am currently with the EBS, and have 21.5 years left on my mortgage, I am on a variable rate of 2.63%. I was thinking of moving to AIB and taking out a 3 year fixed rate, they have a ‘new business’ 3 year fixed rate of 3.19%, but I would have to extend my loan to 23 years in order to match my existing mortgage payment with the EBS, in brief i’m hoping to be able to fix at this rate to avoid any increases in the variable rate comming soon. What’s your advice?.
    Thanks, Anne

  5. alison

    hi karl, im really hoping you can help me. i have 23 years left on my mortgage at a current variable rate of 3.24% with kbc. im thinking of locking into a fixed rate of 3.99% for either 2 or 3 years – this is there maximum they will let me fix for. should i do it this month or leave it a couple of months. even if the ECB dont increase there rates this year, kbc probably will, will they, please reply


Leave a Comment

Awesome! You've decided to leave a comment. Please keep in mind that comments are moderated.