The Shape of the Yield Curve and the Business Cycle

The shape of the yield curve is often cited as a leading reliable economic indicator. The yield curve maps the relationship between interest rates and the maturity of fixed-income investments on a graph. On the horizontal axis is time or maturity, while on the vertical axis are rates that are prevalent in the economy.

Yield Curve as an Economic Indicator

The yield curve tends to be steep at the bottom of the cycle, flatten during the expansion until it is very flat or even inverted at the peak, and re-steepen during the subsequent contraction.

A flattening or inverted yield curve involves downward pressure on long-term rates and upward pressure on short-term rates. With longer-term loans comes more risk to the lender, so an inverted curve is not a logical way for the markets to operate long-term and is thus typically thought of as a harbinger of unsettling times ahead.

Summary of the Yield Curve and the Business Cycle

Bottom of the cycle + Expansion: Steepening yield curve.

At the top of the peak: Flattened or inverted yield curve.

Top of peak + Contraction: Steepening of the yield curve.

Monetary and Fiscal Policy Mix and the Yield Curve

• The yield curve is steep for stimulative policies, and the economy will likely grow.
• The yield curve is inverted for restrictive policies, and the economy is likely to shrink.
• A restrictive monetary policy and a stimulative fiscal policy imply a flat yield curve, and the economic effects are unclear.
• A stimulative monetary policy and restrictive fiscal policy imply a steep yield curve, and the economic effects are unclear.

Question

Which of the following would most likely be interpreted as a sign of economic improvement on the horizon?

1. A flattening yield curve.
2. An inverted yield curve.
3. A steepening yield curve.

Solution

The correct answer is C.

A steepening curve leaves its flatter or inverted form and moves towards a normal and healthy shape, indicating a longer-term expansionary cycle.

A is incorrect. A flattening of the yield curve denotes an economy moving from a standard yield curve toward an inverted yield curve. While this could signal that the economy is still in an expansionary mode, it is more likely that whatever expansion is left will be short-lived as an inverted yield curve is on the horizon.

B is incorrect. An inverted yield curve is known as a predictor of a recession, not an expansion.

Asset Allocation: Learning Module 1: Capital Market Expectations – Part 1 Framework and Macro Considerations; Los 1(i) Interpret the shape of the yield curve as an economic predictor and discuss the relationship between the yield curve and fiscal and monetary policy