Question

Under the Market Segmentation Hypothesis, what drives the actual slope of the yield curve. Under the specification of the term premium provided by this model, what would it mean if the yield curve were inverted?

Answer 1

Yield Curve & Factors
According to the Market Segmentation Theory, there is no relationship between the short term and long term interest rates since both have different investors. The theory suggests the investors prefer to stay in their own bond maturity range because of the guaranteed yield from that. The fear of risk from the yield retains the investors to change their bond maturity range. The driving forces determining the slope of the yield curve are the demand and supply forces within each category or market. Yield curve shows the relationship of the bond and the maturity lengths. Normal, inverted and humped are the three main shapes for the yield curve.
The inverted shape of the yield curve reflects high short term interest rates and low long term interest rates. This may leads to tightening the monetary policies by the central bank as the investors expect the economy to slow down. The inverted yield curve give high interest rates to the investors invested in short term bond maturities. Normal shape shows the slight upward slope reflecting the low short term rates than the long term rates. This is the normal situation of the market. Normal yield curve shows the expectation of the investors about the economy keep growing. Humped shape is about the mixed expectations. Thus inverted shape refers the abnormal situation where the short term rates are higher than the long term ones.