Question

Interpret the following comments made by Wall Street analysts and portfolio managers regarding:

a. Normal yield curve: "An upward-sloping yield curve persists because many investors stand ready to jump into the stock market."

b. Flattening of the yield curve: "The shift from an upward-sloping yield curve to a downward-sloping yield curve sends a warning about a possible recession."

Answer 1

a: Upward sloping yield curve means that the yield is higher with higher maturity. This is because the investors needs to be compensated for higher risk of holding the investments in the bond market. Also they have an option to invest in the stock market rather than bond market and so they have to be compensated for that opportunity loss since they are selecting the bond investments over the stock investment.

b: A shift towards a downward sloping yield curve means that the long term investments are now giving lesser yield. This implies that the investors are losing confidence in the investments and prefer to hold on to their money rather than to invest it. This will create shortage of loanable funds in the economy and hence it pushes the economy towards recession.