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Jargon buster: what's the yield curve?


Published: 30 July 2015 | Author: Sue Anderson

When industry insiders talk about mortgage rates, they often refer to jargon that can seem mystifying to outsiders.

So here, to go alongside Five things you need to know about mortgage rates and How do swaps work?, is a very brief guide to the yield curve, and why it's relevant in the context of understanding mortgage rates.

The yield curve

A yield curve is, in essence, a way of showing what financial markets expect future interest rates to look like. By looking at a yield curve, it is possible to get a feel for the cost of borrowing funds over various timescales.

It plots the "yield" (that is, the overall return) at maturity of fixed income investments such as gilts.

What's "normal"?

The "normal" shape of a yield curve is upward, as investors expect to be compensated for tying up their funds for longer periods.

And when markets expect inflation to rise in the future (as they do now), they also expect interest rates to rise further to compensate for the erosion of value - so the upward shape of the yield curve steepens.

An upward curve will suggest higher rates in the future than at present. So borrowing funds for a longer period will tend to be at a higher rate - which, other things equal, will tend to push up the cost of fixed rate mortgage funding.

The chart below - the overnight index swap forward curve - is often used to look at financial markets' expectations of the Bank rate at different points in time over the next few years. It is also used to imply when the Bank is expected by the markets to raise Bank rate from its current level of 0.5%

Chart 1: Overnight index swap forward curve

Chart showing overnight index swap forward curve

Source: Bank of England 

Download data

What's not normal?

Under different market conditions, the yield curve may be inverted (when markets expect rates in the future to be lower than in the present, because of expectations of a slowing in the economy). This happened before interest rates were cut aggressively following the financial crisis.

More information

The Bank of England publishes various different yield curves - this is pretty technical stuff and not for the fainthearted, but suffice to say for our purposes that they all show a steepening upward curve for at least the next 5 years.

It would appear that what the markets are telling us is that, for mortgage rates, expectations of when and how much are both getting sharper.