I think the question is pretty self explanatory. I'm just trying to understand the logic behind why an upward sloping yield curve indicates a good economy?
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1$\begingroup$ The assumption is incorrect. The yield curve actually tends to be very steeply upward sloping when the economy is in a really bad shape, as the Fed inevitably lowers short rates to reflate the economye (e.g., look at the curve in late 2008). As the the economy heals and inflation pressure builds, the Fed tightens, which causes the curve to flatten (all else equal). Eventually, the tightening and/or capital flows result in a recession, and the curve steepens again as the Fed lowers short rates. Each of these monetary cycles may play out somewhat differently, but broadly they're very similar. $\endgroup$– haginileAug 2, 2018 at 9:09
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$\begingroup$ Quant.SE mod here: I couldn't find a duplicate and I think it fits here so I migrated. Please let me know whether you agree. $\endgroup$– Bob JansenAug 2, 2018 at 12:19
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$\begingroup$ You have to be careful what you are interested in: the current state of the economy or the outlook (forecast). As haginile said a steeply upward sloping curve indicates a terrible economy now, but the bad times may be about to end and the economy abpout to recover from a low point. A flat or downward sloping is a good economy now that may be about to slip into recession soon. $\endgroup$– noob2Aug 2, 2018 at 12:33
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3 Answers
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The prevalent hypothesis for the normal slope of the yield curve is due to a combination of the expectations hypothesis, and a liquidity premium. Recall what the yield curve is measuring- it graphs Yield to maturity against a bond of maturity t, for different time horizons t. This yield to maturity is generally thought of as the interest rate. First, the assumption is that we hold constant the risk profile of the bonds in question- think of just looking at the yields of T-Bills for different horizons. The expectations hypothesis is straightforward: it specifies that the yield to maturity (upto an approximation) of a two year bond is the average of the current yield and the expected future yield. As such, if the yield curve is flat, this would mean that the interest rates are not expected to change. Generally speaking, the yield curve is upward sloping. This can still occur under constant interest rate expectations, because people have a preference for liquidity. As such, not having liquidity for 2 periods is more costly than 1, and hence this premium is reflected in a liquidity premium on the yield curve. However, if the yield curve has a sharp upward slope, the economy is expected to do well. This is because first, output is positively correlated with interest rates. This is, in part, due to the fact that a boom is correlated with increased spending, leading to inflation, and the government controlling money supply (inflation) by raising interest rates.
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That shows economy is expected to grow, there is demand of money, people innovating and developing the society.
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1$\begingroup$ Why is this the case? Could you elaborate? $\endgroup$ Aug 2, 2018 at 5:29
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An upward sloping / inverted yield curve itself does not guarantee anything. You've probably heard that an inverted yield curve has preceded every recession, but there have been many times where the yield curve has inverted and nothing happened.
With regards to your question, I think it's easier to think of why an inverted yield curve might foreshadow something bad with the economy. If everything was guaranteed to be perfect in the future, the return on a 5-year bond, for example, should be roughly equal to buying five 1-year bonds.
But what happens during a recession? The fed decreases interest rates significantly. Thus, the 5-year bond would have a lower yield than a 1-year bond since people expect the interest rate to fall over sometime in the next few years. Similarly, for an upward sloping yield curve, it means that people are projecting an economy with strong growth, as they expect interest rates to increase in the future in order to prevent the economy from overheating.
