NORMAL YIELD CURVE
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.