Question

What is the term structure of interest rates? Why is the term structure normally upward sloping?

How do bond yields anticipate economic activity?

Answer 1

The term structure of interest rates is the relationship between the bond yield for different maturities. In short, bond yields is mapped on the x-axis and bond maturities on the y-axis. In normal circumstances, the term structure is upward sloping. This means that as the time to maturity increases, bond yields also increase. This is due to the fact that investor requires more premium to compensate for additional risk taken for investing over a longer time horizon. Longer the bond maturity, higher are the risks associated, and hence higher is the yield demanded by the investors.

When the yields on long-term maturity bonds rise faster than those on short-term maturity bonds, this indicates that the long-term bonds are underperforming short-term bonds. In short, the yield curve is steepening. This typically indicates an environment in future where investors predict a stronger growth ahead in the economy.Conversely, if the graph is inversely sloped, or the yields on long-term maturity bonds rise slower than those on short-term maturity bonds, this indicates that the long-term bonds are outperforming short-term bonds, thus indicating that investors are predicting slump in the short-run.