I am kind of trying to figure out mechanics of how the yield curve changes with time throughout the different stages of the economic cycles. Does anyone have any tips on how to learn this easily?
Think of the yield curve as an economic indicator, with the short end being a year or so out and the long end being 5-10 years out. When the economy is going to do well, we expect rates to rise and when the economy is going to struggle, we expect rates to fall. So let’s say we are at the bottom of an economic cycle (trough / worse part) of a recession, we would expect that short term rates have already been dropped and wont go any lower, while longer term rates will be higher, as the economy should be doing well in the future. Therefore we have a steep, upward-sloping curve toward the end of a recession - which indicates the economy is expected to do well, and central banks will raise rates in the mid-term to keep pace with inflation and an economy operating beyond its potential output. (Positive output gap)
Now let’s take the opposite - the economy had been booming but has begun to show signs of slowing down, albeit while still growing. Therefore we can expect that the economy will enter a recession before it will begin a strong expansion, therefore the yield curve inverts, with short term rates high right now (to stop the economy from overheating - but won’t go much higher) but will eventually fall in the longer term as the economy begins to struggle. This leads to an inverted yield curve at the tail end of an expansionary (mature) phase.
Between scenario 1 & scenario 2, the yield curve goes from steep to inverted, therefore it begins to flatten through the expansionary phase.
Hopefully this helps.
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Oh man! That was amazing.