Question

Suppose that the Liquidity Preference Theory of the term structure is correct and that you observe an inverted (downward-sloping) yield curve. Is it possible that the market expects short-term rates to increase in the future? Explain.

Answer 1

Liquidity Preference Theory states that the investors always prefer a higher rate of return/ interest on the long term securities or on those securities which carry a higher risk and prefer to have cash or liquid assets at a minimal rate. Reason being less risky and not sacrificing the liquidity hence no boundations on using the their funds as per the requirement and could be easily sold out at the face value itself. Thats why the interest rates on the liquid assets are less and get higher interest on long term and medium term maturity funds. For e.g, the interest for one to two years on commercial papers as well as treasury notes are very less ranges maximum 1.5% to 2 %.

Considering the above facts, the yield premium or interest rates increase with the increase in maturity. Henceforth, this supports the theory - Liquidity Preference Theory. Based on empirical study, the forecasting of future short term interest rate for short tem is determined based on the forecasting of interest rate of long term securities. Both go hand in hand, if the rate of interest for bonds decreases the investor would prefer to invest in some other high premium securities or would like to keep it liquid until and unless she finds a better option to invest in.

Also, the short term interest rates are depends upon the new information which is just next to unpredictable. Hence, we can ay that their is poor predictability for the short term rates wether it would increase or decrease in future or not.