The current yield curve for Country Y suggests that the business cycle is in the slowdown phase ( curve is flat to inverted ), with bond yields starting to reflect contractionary conditions (i.e., bond yields are declining). The curve will most likely steepen near term, consistent with the transition to the contractionary phase of the business cycle, and be the steepest on the cusp of the initial recovery phase.
Please tell me the following:
how come slowdown phase implies that curve is flat to inverted?
why it is consistent with contractionary phase to have a steepen curve? It is written everywhere that contractionary phase implies yields to decrease (thus, go down, right?)
why yield curve is steepest in initial recovery? It is written everywhere that initial recovery phase implies yields to decrease (thus, go down, right?)
An inverted or flat yield curve is a good predictor of a future recession. This invertion of the curve is mostly driven by investors expectations about future economic performance.
(1) When investors expect a recession, it is widely known that central banks are going to reduce interest rates in the upcoming months/years in order to reactivate the economy again. So, longer maturity yields go down, even lower than short-term rates (that are still not affected by expectations because they will come due before recession takes place).
(2) As said in (1), investors expect a fall in interest rates, so they will try to “lock” in instruments with long maturities and higher yields (sold now) and expect the highest price revaluation of bonds because long maturity bonds are very sensible to changes in interest rates. Investors will want to buy now longer maturity bonds bringing the long-term rates even lower.
As you can see, this also matches with the strategy of “flight to quality” when recession is expected. Investors sell their equities and buy bonds.
With the same reasoning, when the economy starts to go out recession, the yield curve steepens again reflecting expectations of future increments in interest rates and investors selling long-term bonds and flying to equities.
Yes to your question regarding interest rates and not GDP growth rates. During initial recovery, since your interest rates are low, firms can borrow more, invest more into their businesses. Consumers can borrow more to spend more, leading to growth in economy. Due to this constant borrowing, spending and investing, prices rise leading to inflation. As inflation keeps increasing over the years, interest rates too will start increasing over a period of time to combat inflation, leading to a steep yield curve over the long run. Imagine initial recovery as shorter short term rates and increased longer term rates, steepening your yield curve.
A yield curve depicts interest rates quoted TODAY of debt instruments with different maturity…
The yield of a 3-month T-bill quoted today can be 2% (annualized)
The yield of a 30-year bond quoted today can be 8% (annualized)
Graph those rates, and you will see a steeped curve.
But, why the difference of interest rates?
Because of risk premiums included in the yield. You may have seen that a nominal interest rate is a composition of a real interest rate plus risk premiums:
Real interest rate
(+) Expected inflation risk premium
(+) Credit risk premium
(+) Maturity risk premium
(+) Other risk premiums
= Nominal interest rate (yield)
In the example of a T-bill, we can say that its maturity risk premium is quite lower compared with the maturity risk premium included in the 30-year bond. A 30-year bond has higher probability of not reaching its maturity therefore to default, so the investor will require a bigger compensation in form of interest rate (a risk premium).
Remember the yield curve depicts rates of different maturities quoting right now. The yield curve may change tomorrow.
However, an upward slope yield curve may reflect the expectation of future increment of interest rates, but we are entering to advanced knowledge here, so better stop for now. Assimilate this first.