steepening yield curve

[mrb102189]

I’m having trouble with the concept of a steepening yield curve. It assumes that short-term yields fall relative to long-term yields, so short-term maturuties would perform better. I guess my question is- is this a good sign for an economy or maybe not even a long-term sign at all? And then conversely, if the curve flattens- is that a bad sign since LT yields are coming down?
I think I’m confused because the example I came across assumed in both cases that yields were coming down, and just stated that steepening meant they were coming down more in the shor-term…but I’m trying to get at what could actually, in a real economy, make the yield curve flatter or more steeper…
thanks as always you guys are super helpful.

 

[Harrogath]

Interest rates represent opportunity cost of money; and in an economy where info is complete and free, investors press demand and supply of money with their expectations about the performance of whole market, either in the short term and the long term.
If short-term interest rates are low, then the investors believe the performance of the market is or will be relatively bad during the short term. The opposite is true when short-term interest rates are high.
In the other hand, if the long-term interest rates are high (higher than short-term rates), investors believe the performance of the market will be relatively good in the long term. They expect the economy to improve when the long term finally becomes the short term. The opposite is true when long-term interest rates are low.
So, what a steeper yield curve means? In simple words: “Investors believe, today, the economy to better as the time passes”. Really common to see steep curves in many countries, this can prove the optimistic view investors have about their relevant economies. Of course, those views can turn bad and the yield curve reverts.
Hope this helps.

 

[krokodilizm]

An important outcome of this is that investors “ride the yield curve” when it is steep. They buy bonds with maturities longer than is their invesment horizon because they know they can sell it in a couple of years with capital gains.

 

[MissSongJ]

Just to add on to what Harrogath and krokodilizm have explained, when a curve starts to flatten, it’s generally in a bad sign as you’ve mentioned because:
a. It means in short term, invetors are uncertain about the market condition, hence require more compensation on the investment, namely higher short term yield
b. If investors use long term debt instruments as safe haven, demand for long term bonds will go up, their prices goes up, yield goes down.
Normally people require higher long term interest rates to compensate for the higher risk and uncertainy of longer investment horizon, but in volatile market condition, short term rate could go up (due to the reasons stated above) and eventually surpass long term rate, this would result in inverted rates curve.
We could ovbserve this in the latest financial crisis / EU crisis, hence central banks have to step in to force the short term interest rate down in order to discourage savings, encourage investments and hopefully re-vitalise the economy.
Hope that helps and please feel free to correct me if I’m wrong.

 

[Harrogath]

You are totally correct MissSongJ.
Thanks for adding your explanation.