Technically, the Treasury yield curve can change in various ways: it can move up or down (a parallel shift), become flatter or steeper (a shift in slope), or become more or less humped in the middle (a change in curvature).
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Consider three elements of this curve. First, it shows nominal interest rates. Inflation will erode the value of future coupon dollars and principal repayments; the real interest rate is the return after deducting inflation. The curve therefore combines anticipated inflation and real interest rates. Second, the Federal Reserve directly manipulates only the short-term interest rate at the very start of the curve. The Fed has three policy tools, but its biggest hammer is the federal funds rate, which is only a one-day, overnight rate. Third, the rest of the curve is determined by supply and demand in an auction process.

First, the two rates move up and down somewhat together. Therefore, parallel shifts are common. Second, although long rates directionally follow short rates, they tend to lag in magnitude. When the Fed raises short-term rates, long-term rates increase to reflect the expectation of higher future short-term rates Specifically, when short rates rise, the spread between 10-year and one-year yields tends to narrow (curve of the spread flattens) and when short rates fall, the spread widens (curve becomes steeper).

This entry was posted on Sunday, October 12th, 2008 at 12:06 pm and is filed under Banking and CD Guide. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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