How Monetary Policy Shapes Interest Rates in 2025
Interest rates are a crucial element of economic performance and key instruments in monetary policy. The term structure of interest rates, which is commonly visualized with a yield curve, describes how government bond yields differ from their time to maturity. This structure indicates inflation, economic growth and the stance of monetary policy.
Before we dive into the term structure of interest rates, it is important to understand some foundational concepts.
Spot Rate: The rate of return earned when the investor buys and sells the bond without collecting coupon payments. This is extremely common for short-term traders and market makers.
Yield to Maturity (YTM): The total rate of return that will have been earned by a bond when it makes all interest payments and repays the original principal
What is the Term Structure of Interest Rates?
It represents the relationship between interest rates (or yields) on debt instruments that have the same credit quality but different maturities. These maturities can range from very short term (ex: 1 month) to very long term (ex: 20 or 30 years).
The graphical plot of yields across these maturities is called the yield curve.
Chart From https://www.worldgovernmentbonds.com/country/sri-lanka/
The graphical representations can be shown in several shapes:
Normal (Upward Sloping): Longer maturities pay higher yields to compensate for risk that incurred over time, expecting stronger growth and inflation.
Flat: No much difference between short and long-term yields, which indicates economic uncertainty.
Inverted (Downward Sloping): Long term yields are lower than the short-term yields signaling impending economic slowdown.
Humped: An interest rate curve in which medium-term interest rates are higher than both short-term and long-term rates.
Steep: The yields on long-term bonds are rising faster than yields on short-term bonds, or short-term bond yields are falling as long-term bond yields are rising.
Understanding a few theories are essential in order to determine why interest rates differ by maturity.
1. Expectations Theory
This theory explains the term structure of interest rates is the proposition that the long-term rate is determined purely by current and future expected short-term rates, in such a way that the expected final value of wealth from investing in a sequence of short-term bonds equals the final value of wealth from investing in long-term bonds assuming that all maturities are perfect substitutes.
Chart from https://fastercapital.com/topics/the-expectations-theory-of-interest-rates.html
2. Segmented Markets Theory
The interest rate curve is actually differentiated in segments based on the bond maturity required by investors and each segment is independent to each other. So short term bond rates are not related to long term bonds and vice-versa and therefore, the yields of each segment are determined independently.
Key notes:
Interest rates at each maturity depend on supply and demand within that segment.
Explains the yield curve shaped by distinct investor preferences and market segmentation.
Chart From https://www.wallstreetmojo.com/segmented-market-theory/
3. Liquidity Premium Theory
This theory states that investors require additional compensation, a liquidity premium, for holding long-term securities. It is based on the idea that investors prefer shorter-term, more liquid investments.
Chat from http://contents2.kocw.or.kr/KOCW/document/2016/hanyang/namdeokwoo1/4.pdf
When it comes to risk structure and interest rates, it can vary by its credit risk:
Default Risk: Government bonds are generally considered as risk-free in domestic currency, providing a baseline yield.
Credit Risk Premium: Corporate or lower-rated bonds include extra yield to compensate for higher risk.
Let’s explore what’s happening with the term structure of interest rates in Sri Lanka.
Sri Lanka’s government securities (Treasury bills and bonds) form the backbone of the term structure. The Central Bank of Sri Lanka (CBSL) is doing a key role by setting policy rates that influence short-term yields and ultimately the entire yield curve.
There have been significant changes in Sri Lanka’s monetary policy during the past few years.
November 2024:
CBSL introduced the Overnight Policy Rate (OPR) at 8.00%, replacing the dual system of Standing Deposit Facility Rate and Standing Lending Facility Rate. SDFR and SLFR were set 50 basis points around the OPR (7.50% and 8.50% respectively).May 2025
The OPR was cut by 25 basis points to 7.75%, as inflationary pressures ease and support steady economic growth. The SDFR and SLFR were adjusted to 7.25% and 8.25% respectively.
July 2025
CBSL held the OPR steady at 7.75% in order to balance out the inflation target (5%) and GDP growth (around 4.8%) within Q1 2025.
Here are some yields from the current bond market (as 29th of July , 2025).
Chart from Bartleet Morning Market Brief
182-day and 364-day Treasury Bills: Yields have decreased from the start of the year (around 9.8%), and it suggests that short-term borrowing costs have eased over the year, reflecting ongoing accommodative monetary policy.
Average Weighted Prime Lending Rate (AWPR): This rate has decreased 10.6% from the start of the year, which results in lower borrowing costs.
AWNLR (No Loan Rate), AWDR (Deposit Rate), and AWNFDR (Fixed Deposit Rate): These have shown notable decreases of 5.3% to 8.4% compared to the year-open, indicating lower deposit and saving rates this year, with the monetary easing and favorable liquidity conditions.
The market has a positive liquidity surplus of about LKR 102.87 billion currently, meaning there is excess liquidity available in the banking system. A surplus indicates easier monetary conditions where banks have more funds to lend, supporting credit growth and economic activity.
Why the Term Structure Matters
Investors use the yield curve to manage interest rate risk and plan portfolios.
Businesses rely on it to decide on financing costs for different time horizons.
Policymakers monitor its shape to measure the effectiveness of monetary policy and predict economic cycles.
It acts as a key economic indicator, forecasting growth or recession depending on its shape.
The term structure of interest rates indicates insights about inflation, economic growth and monetary policy. Sri Lanka’s current upward sloping yield curve reflects cautious optimism about sustained growth and controlled inflation. Understanding this structure is essential for investors, businesses and also policymakers to make informed financial decisions. As the economy evolves, monitoring the yield curve remains crucial for anticipating future interest rate movements and economic conditions.
References
https://www.investopedia.com/terms/m/market-segmentation-theory.asp
https://www.fe.training/free-resources/financial-markets/term-structure-of-interest-rates/
https://www.sciencedirect.com/topics/social-sciences/term-structure-of-interest-rates
https://www.investopedia.com/terms/t/termstructure.asp
https://www.adaderana.lk/news.php?nid=103799
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