Yield curve
Capital MarketsThe plot of government bond yields against maturity, and the market's summary view of growth and rates.
The yield curve shows what investors demand to lend to a government for different lengths of time. Normally it slopes upward, since lending for longer carries more risk and more uncertainty about inflation.
It matters for valuation because the risk free rate in any cost of equity comes off it, and the point chosen should match the duration of the cash flows being discounted. A long dated DCF using a two year yield has mismatched them.
An inverted curve, where short rates exceed long ones, says the market expects rates to fall, which usually means it expects the central bank to be cutting because growth has weakened. It has preceded most recent recessions, which is why it draws so much attention.
It also drives bank profitability directly, since banks borrow short and lend long. A steep curve widens the spread they earn; a flat or inverted one compresses it regardless of how well the bank is run.
Worked example
Two year yields at 3.6% against ten year yields at 2.9% is an inversion of 70 basis points.
The market is saying it expects rates to fall, which usually means it expects the central bank to be cutting because growth has weakened.
For a DCF, take the risk free rate from the point matching the cash flows, so a long dated forecast uses the 2.9% rather than the 3.6%, or the discount rate embeds a view about the next two years rather than the next twenty.