Questions: Term Structure of Interest Rates

Question 1

The yield curve is currently upward-sloping (normal). Under the pure expectations theory, what does this shape imply?

• A. The market expects interest rates to remain stable — the slope just reflects inflation risk
• B. The market expects future short-term rates to be higher than today's short-term rates
• C. Long-term bonds are riskier, so investors automatically demand higher yields regardless of rate expectations
• D. The central bank has set long-term rates higher than short-term rates

Answer: (B)

Under pure expectations theory, the long-term rate equals the geometric average of expected future short-term rates. An upward-sloping curve means long rates exceed short rates, which requires expected future short rates to be higher than current short rates. Option C describes the liquidity preference theory, not pure expectations. Option D misunderstands the yield curve: the central bank directly controls only short-term rates; long-term rates are set by bond markets reflecting expectations and term premiums.

Question 2

Under the liquidity preference theory, why does the yield curve typically slope upward even when short-term rates are expected to remain flat for years?

• A. Because longer-maturity bonds have higher default risk
• B. Because investors demand a term premium to compensate for the uncertainty and illiquidity of holding long-term bonds
• C. Because the central bank pegs long rates above short rates to encourage saving
• D. Because inflation is always expected to rise in the long run

Answer: (B)

The liquidity preference theory adds a positive term premium on top of expected future rates. Even if investors expect short rates to stay flat at 2% forever, they still demand something extra — say 0.5–1% — to lock up money for 10 years rather than rolling over short-term bonds. This term premium compensates for price volatility risk (long bonds fall more when rates rise) and liquidity risk. This is why a flat-expectation world still produces an upward-sloping curve. The normal upward slope reflects both expectations and this premium layered on top.

Question 3

An upward-sloping yield curve typically indicates that the market expects interest rates to rise in the future.

• T. True
• F. False

Answer: False

Under liquidity preference theory, the yield curve can slope upward even when the market expects future short rates to stay flat or even fall slightly, because the term premium adds a positive increment to long-term yields regardless of rate expectations. A steeply upward-sloping curve might reflect high term premiums rather than strong expectations of rate increases. Distinguishing expectations from term premiums requires additional analysis (e.g., comparing implied forward rates to survey-based rate expectations).

Question 4

A yield curve inversion (short-term rates exceeding long-term rates) has historically been a reliable leading indicator of recessions.

• T. True
• F. False

Answer: True

Every U.S. recession since the 1970s has been preceded by an inverted yield curve, typically 12–18 months earlier. The mechanism: an inversion means markets expect future short rates to fall substantially, which happens when recession and central bank easing are anticipated. Additionally, an inverted curve directly tightens bank lending — banks borrow short and lend long, and when short rates exceed long rates, this spread turns negative, making new lending unprofitable. This credit tightening itself contributes to the recession the curve predicted.

Question 5

Why has an inverted yield curve historically predicted recessions? Explain the mechanism, not just the correlation.

Model answer: An inverted yield curve (short rates > long rates) signals that bond markets expect future short-term rates to fall substantially. Under most theories, long rates reflect expected future short rates. Rates fall when the central bank eases policy — which typically happens in response to recession. So the inversion itself is the market's forecast of future easing, which implies an expected recession. Beyond prediction, the inversion also causes economic damage: banks fund themselves short-term and lend long-term, so when the yield curve inverts, the spread on new loans turns negative, causing banks to tighten credit. This credit contraction reduces business investment and consumer spending, helping to create the very recession the curve predicted.

The yield curve is both a predictor and a partial cause of recessions — the mechanism runs both ways. Understanding this requires connecting the term structure theories (why the inversion signals expectations of lower future rates) with the banking channel (why a negative spread directly impairs lending). Neither alone tells the full story.