P81 of the Trading book (Reading 30 Monitoring and Rebalancing), it says (2nd paragraph) that yield curves tend to become steeply upward sloping during recessions, flatten in the course of expansions and are downward sloping before recessions.
Can someone please explain?
In another reading, it said that in a strong economic upswing , the yield curve is upward sloping (due to increased future loan demand it seems), meanwhile, here it says that upward sloping curve occurs during recessions.
I think the question here is why they would be upward or downward sloping in either economic environment.
In the case of a recession, the supply and demand dynamics play a larger factor pressuring yields higher as a reflection of uncertainty through a higher risk premium on the long end. In a strong expansion, the upward curve is more a representation of inflation expectations.
When in a recession, interest rates on the shorter maturities end of the curve fall since central banks would cut short term interest rates to boost the economy. The assumption is that this rate cut is positive for the economy and will spur it up causing inflation over time and thus higher rates in the long term making the curve steep.
But if the yield curve is downward sloping, it indicates a possible recession in the future.
Because the government’s monetary and fiscal policy will be expansionary in a recession.
Monetary = lower interest rates by central bank, pulling down front side of the curve.
Fiscal = more government spending. More government spending (in theory) leads to more inflation. More inflation leads to higher bond yields required. Back end of curve shifts up.
Low front end and high back end is a steeper curve.
Makes sense. I think if you answered it like that on the exam, you probably wouldn’t get any points though because none of that is in the cirriclum… like it says in a recession the curve is upward sloping because of increased maturity premium
First of all, they will not ask you for a reason to explain why yield curves are upward sloping during recessions, but why yield curves may be upward sloping during recessions.
It’s not a rule, and anything is possible with a multitude of causes in economics.
Yield curves tend to be flat or inverted immediately before recessions, flat or moderately upward sloping during most of recessions, and sharply upward sloping near the end of (but still during) recessions.
Oh, and… does that mean that in expansions they’re downward sloping? because in the front-end of the yield curve rates are higher to cool the economy? + maturity premiums are falling (in good times?) … That’s the final piece to the missing puzzle
Usually yield curves are upward sloping during expansions.
(Note that I have a whacking big advantage of having just produced Level II PowerPoint slides for reading 55 at Level II: Economics for Investment Markets. They talked at length about the shape of the yield curve at different points in the business cycle.)
