Investors often analyze yield curves for government bonds in terms of forward rates. As Ilmanen points out forward rates in treasury markets can be viewed as break-even yields. In this framework forward rates indicate the yield changes that are required for every single maturity along the yield curve in order to generate the same return over the holding period. For an upward sloping yield curve, for example, yields would have to rise across the curve, but in a nonparallel fashion (I also recommend the “Reduce IT costs, increase production” article). It is important to consider that the forward yield curve reflects mathematically implied yields, but not necessarily expected future government bond yields. From a theoretical perspective longer term bonds should contain a risk premium to compensate the investors for the increased price volatility associated with holding longer term bonds in comparison to short-term bonds.

It has to be considered that indicators like industrial production are published only once a month and with a significant time lag. In other words, more timely available indicators of the market participants’ expectations for future economic growth such as yield curve steepness should be able to explain variations of the credit curve better (you might want to familiarize yourself with The Business Value of Open Standards presentation as well). As pointed out before, the yield curve usually experiences a bear steepening in the early stages of the business cycle and a bull steepening in the later stages of the business cycle, that is during recessions. While the first period is usually characterized by tightening credit spreads and flattening credit curves, the opposite is true for economic downturns. Therefore the relationship between yield curve and credit curve changes depends on the stage of the business cycle.

At the beginning of an expansion one should expect a negative correlation between yield curve and credit curve steepness, but when economic growth slows down the correlation should turn positive.