NOR­MAL YIELD CURVE

Finweek English Edition - - Openers -

FROM THE post-Great De­pres­sion era to the present the yield curve has usu­ally been “nor­mal” – mean­ing that yields rise as ma­tu­rity length­ens (ie, the slope of the yield curve is pos­i­tive). That pos­i­tive slope re­flects in­vestor ex­pec­ta­tions for the econ­omy to grow in the fu­ture and, im­por­tantly, for that growth to be as­so­ci­ated with a greater ex­pec­ta­tion that in­fla­tion will rise in the fu­ture rather than fall.That ex­pec­ta­tion of higher in­fla­tion leads to ex­pec­ta­tions that the cen­tral bank will tighten mone­tary pol­icy by rais­ing short­term in­ter­est rates in the fu­ture to slow eco­nomic growth and dampen in­fla­tion­ary pres­sures. It also cre­ates a need for a risk pre­mium as­so­ci­ated with the un­cer­tainty con­cern­ing the fu­ture rate of in­fla­tion and the risk that poses to the fu­ture value of cash flows. In­vestors price those risks into the yield curve by de­mand­ing higher yields for ma­tu­ri­ties fur­ther into the fu­ture.

How­ever, a pos­i­tively sloped yield curve hasn’t al­ways been the norm. Through much of the 19th Cen­tury and early 20th Cen­tury the US econ­omy ex­pe­ri­enced trend growth with per­sis­tent de­fla­tion, not in­fla­tion. Over that pe­riod the yield curve was typ­i­cally in­verted, re­flect­ing the fact that de­fla­tion made cur­rent cash flows less valu­able than fu­ture cash flows. Over the pe­riod of per­sis­tent de­fla­tion a “nor­mal” yield curve was neg­a­tively sloped.

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