Question

During a meeting, two analysts are discussing the level of interest rates the economy has experienced recently. One analyst remarks: "We are going through a change in the inflation expectations as we have an inverted yield curve. Surely the investors are expecting lower interest rates and lower inflation in the future." Describe in detail what should be understood by the analysts statements and determine why they may be wrong or why they may be right?

Answer 1

An Inverted yield curve means the short term interest rates are higher compared to the long term. This situation arises when investors are bidding more for long term bonds- and this higher demand results in their lower yields. On the other hand, due to lower demand of short term bonds, they require to provide higher yields to attract the investors again. The reason behind such action is that the investors do not have too much good expectations from the short term investments. So the above statement might seems to be a correct one as it can be a indicator for incoming recession.

But on the contrary, this not always correct. A good example of that is 2008 recession, when the inverted yield first appeared in 2005. The fed concerned of housing bubble started raising rates in 2004 which resulted in an inverted yield situation by 2005. Fed kept on raising the rate until 2007 and then when it started cutting down the rate, the yield curve became upward sloping but market was at a deep recession.