The relevance of the yield curve

The relevance of the yield curve

Creating a future stress scenario for the yield curve is not easily done. Above all, it is something that has to be done carefully, because it can have negative repercussions for a financial institution.

The yield curve provides an indication of the interest rate at which governments can borrow money for different maturity periods. In the financial sector the yield curve plays a pivotal role, because of the amount of information it represents. Decisions made on the basis of this information not only affect people working in the financial sector, but in society as a whole. Examples demonstrating the importance and relevance of the yield curve are legion.

In the US, the yield curve is currently inverted. Generally speaking, the interest rate at which governments can borrow increases as the loan’s maturity period lengthens. This is because the risk of bankruptcy or rising inflation increases over time. However, at the moment the interest rate at which the US government can take out a loan for three-months is higher than it is for a ten-year loan. This type of yield curve inversion typically precedes an economic crisis in the US. In fact, every US recession since 1960 has been preceded by a yield curve inversion. Only once has an inversion not been followed by an economic crisis.

In Germany, the interest rate currently paid by the government for a 30-year loan is negative. Some investors are hopeful that this, coupled with poor economic growth rates, will convince the government that it needs to pursue a policy of fiscal stimulation. In the past, the German government has resisted doing so, but the current negative interest rate seems to have made it a real option. The interest rate on 30-year government bonds is also negative in the Netherlands. This low interest rate has stimulated the Dutch government to explore the possibility of setting up an investment fund with borrowed money. This fund could then be used to finance private and public investments that would be advantageous for the Netherlands’ earnings model in 20 to 30 years’ time.

The importance and relevance of the yield curve is also evident in its application in discounting future cash flows. In a recent airing of a Dutch TV program called Buitenhof, former Dutch Minister of Finance Jeroen Dijsselbloem indicated that pension funds “should not get ahead of themselves”. The difference between the arithmetic yield curve that pension funds apply in the valuation of their future obligations, and the actual yield curve in the market, is simply too big. For this reason, pension funds should just lower the interest rate. However, this would affect everyone who has accrued a pension through his or her employer.

The pivotal role that the yield curve plays in the financial sector means that it must be approached very carefully when carrying out a stress test. In the real world this means that all available information must be assessed and, if necessary, used to generate a stress scenario for the yield curve. My preference here would be to opt for a method that generates an econometric model using clearly interpretable parameters founded on historical data. Based on expert judgment, these clearly interpretable parameters can then be stressed and used as input in a Monte Carlo simulation model to generate scenarios. Combining econometrics and expert judgment will ensure that the yield curve is treated with the respect that it deserves.

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