Question

Please explain why long-term rates are usually higher than short-term rates

Please explain under what economic conditions long-term rates might not be higher than short-term rates.

Please use "the yield curve" in your answer and Please explain your answer "in detail"

Answer 1

Long-term rates are usually higher than short-term rates because of time risk, or maturity risk. Long-term lending involves more risk to the lender as their investment is locked up for a longer time. Higher risk always demands higher returns. Hence lenders demand higher yields (rates) for long-term bonds than short-term bonds.

This is the reason the yield curve is normally upward sloping. A yield curve is a line graph with maturity of bonds on the X-axis, and interest rates (yields) on the Y-axis. As short-term rates are usually lower than long-term rates, the yield curve slopes upwards.

However, in the case of investors losing confidence in the short-term prosperity of the economy, short-term rates may be higher than long-term rates. This is because investors are expecting a recession. In such a case, investors prefer long-term bonds to short-term bonds as there is no confidence about the well-being of the economy in the short-term. Since investors prefer long-term bonds, the prices of long-term bonds will stay high, and the yields will be low. Bond prices and yields are inversely related, i.e. higher bond prices mean lower yields, and lower bond prices mean higher yields. In the case of investors expecting a recession, short-term bonds will fall in price (and have higher yields) and long-term bonds will rise in price (and have lower yields). This results in an inverted yield curve.