Questions: Term Structure of Interest Rates

Question 1

The yield curve inverts — 2-year Treasury yields are now higher than 10-year yields. What does this most likely signal about market expectations?

• A. Markets expect inflation to rise sharply over the next decade, pushing long-term rates up
• B. The Federal Reserve has lost credibility, so long-term bonds are being sold off
• C. Markets expect short-term rates to fall in the future — typically anticipating an economic slowdown or recession
• D. The supply of long-term bonds has decreased, lowering their yields relative to short-term bonds

Answer: (C)

Under the expectations hypothesis, long-term rates reflect the market's average expected short-term rates over the horizon. If 10-year yields are below 2-year yields, it means the market expects short-term rates to fall substantially over the coming years. Historically, this pattern (central bank cutting rates in response to economic weakness) has reliably preceded recessions with a 6–18 month lag. Option A would predict rising long-term rates (to compensate for inflation), not falling ones. Yield curve inversion is one of the most closely watched leading indicators precisely because it aggregates market participants' expectations about future monetary policy and growth.

Question 2

The liquidity premium theory of the yield curve argues that long-term rates exceed the pure expectations value because:

• A. Longer bonds are more liquid (easier to trade), so investors accept lower yields on them
• B. Longer bonds are more sensitive to interest rate changes (higher duration), so investors demand a risk premium
• C. Central banks deliberately keep short-term rates low, creating a wedge between short and long rates
• D. Inflation expectations are always higher for longer horizons, mechanically raising long rates

Answer: (B)

The liquidity premium (or term premium) theory adds a risk adjustment on top of the expectations hypothesis. Longer-maturity bonds have greater duration — their prices fluctuate more when interest rates move. An investor holding a 10-year bond is exposed to more interest rate risk than one holding a 1-year bond. To compensate for bearing this additional uncertainty, investors demand a higher yield. This premium is over and above whatever the expectations hypothesis predicts from expected future short rates. The term 'liquidity premium' is somewhat misleading — it's really a duration/risk premium, since long-term Treasuries are actually quite liquid. Option A confuses direction: higher liquidity would lower yields (investors accept less for easier-to-sell assets).

Question 3

An inverted yield curve signals that markets expect short-term interest rates to fall in the future, which is typically associated with anticipated economic slowdown.

• T. True
• F. False

Answer: True

Under the expectations hypothesis, the long-term rate equals the geometric average of expected future short-term rates over that horizon. If 10-year yields fall below 2-year yields, the market is pricing in significant short-rate declines over the coming decade — a signal that monetary easing (rate cuts) is expected, which central banks typically do in response to recessions. This is why yield curve inversions have historically preceded recessions with high reliability: the bond market is aggregating millions of investors' forecasts into a single observable price signal. The inversion doesn't cause the recession; it reflects the expectation of one.

Question 4

When the Federal Reserve raises the federal funds rate, most points on the yield curve shift upward proportionally, keeping the curve's shape unchanged.

• T. True
• F. False

Answer: False

This is the misconception the topic's 'Common Misconceptions' directly flags: different maturities respond differently to economic changes. The Fed directly controls very short-term rates (overnight, 1-month), so the short end of the curve rises sharply. Long-term rates, however, are driven by long-run growth and inflation expectations, which the Fed influences only indirectly and over time. A rate hike cycle often steepens or flattens the curve — or even inverts it — depending on how markets interpret the Fed's actions for the long-run outlook. Level and shape are genuinely independent dimensions of the yield curve.

Question 5

Explain why the level of interest rates and the slope of the yield curve are considered independent pieces of information, and what each one tells us about economic conditions.

Model answer: The level (the average height of the yield curve) reflects current monetary conditions — whether rates are generally high or low, driven by central bank policy and current inflation. The slope (upward, flat, or inverted) encodes market expectations about where rates are headed — it reflects the difference between what short-term rates are now versus what the market expects them to be in the future. A steeply upward-sloping curve can exist at either 2% or 8% average rates; a flat curve can also exist at either level. They measure different things.

Confusing level and slope leads to systematic errors in bond analysis. A high-rate, flat curve means rates are currently elevated but expected to stabilize — different from a high-rate, steeply upward-sloping curve (rates high now, expected to rise further). A low-rate, inverted curve is particularly significant: it signals that even though rates are low, the market expects them to go lower still — a recession warning. Reading both dimensions simultaneously gives a much richer picture of market expectations than tracking the overall rate level alone.