Question

In reference to the lecture we had about the yield curve, the lecture note and the video posted in the topic 1 folder in the Course materials, discuss:

1. What is inverted yield curve? (2 points)

2. Why is it interpreted as the sign of imminent recession? (4 points)

3. What causes the inverted yield curve? (4 points)

It is absolutely crucial to provide the logical reasoning & the schematic account of the financial market process.

Answer 1

1) Inverted yield curve refers to a situation in which the short term interest rates are higher compared to the long term interest rates. Generally, long term interest rates are higher than hort term owing to the fact that there is a risk premium associated with time.

2) When the market participant or investors speculate that the short term interest rates are higher, the yield curve inverts. This happens when they feel that in the short run, there would be recession leading to a decreased demand and hence lower interest rates. However, in the long term, interest rates are higher than the short term interest rates suggesting that a recession would be imminent in a short time.

3) Inverted curves are caused when, let's say 10 year bond yields fall below 2-year bond yields. This essentially means that investors are sceptical about the market scenario and do not want to take undue risk by investing higher in any short term time period. This causes the inverted yield curve as the demand for higher term bonds becomes higher, and the demand for short term bonds is less because market is expecting a recession in the short run.