8.4) Yield Curve and Economic conditions

Question 1

Why do academics and practitioners believe the yield curve predicts economic conditions? (2)

Answer 1

• The yield curve reflects market sentiment and
• The market sentiment is always “right”
  o Explains what market is thinking about the future

Question 2

Why is the market correct? (2)

Answer 2

1. They can see it coming – prediction is correct.
2. Knowledgeable enough to take a position to avoid losses

Question 3

Why is the yield curve associated with boom/recession? (3)

Answer 3

• High real interest rates and high inflation (high nominal rates) - The demand for more creates high interest rate
• Central bank will be hawkish
• Upward sloping curve - In a boom investor know interest rate will be high and High nominal interest rates (more demand for money)

Question 4

What are the conditions in a recession? (3)

Answer 4

• Low real interest and low inflation (Low nominal interest rates)
• Central bank will be dovish
• Inverted yield curve/downward sloping
  o In recession investors know interest rates will be low
  o Low nominal interest rates (less demand for money)

Question 5

NB: Nominal interest rate = _____ rate + _________ rate

Answer 5

Real
Inflation

Question 6

What happens if the market anticiaptes a recession? (5)

Answer 6

• Investors shift funds from short-term to long-term bonds
• Borrowers shift to short-term funding bonds
• Short-term bonds: ↓ prices, ↑ yields
• Long-term bonds: ↑ prices, ↓ yields
• Inverted yield curve → predicts a drop in future spot rates and a lower real GDP

Question 7

What happens if the market isa nticipating a boom? (5)

Answer 7

• Investors shift funds from long-term bonds to short-term bonds
• Borrowers shift to long-term funding bonds
• Short-term bonds: ↑ prices, ↓ yields
• Long-term bonds: ↓ prices, ↑ yields
• upward-sloping curve

Question 8

Summarise normal, inverted and humped yield curves on:
-economy
-inflationary risk and short term rates
-steepness

Answer 8