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If you plot yield of govt bonds against the log of the time to maturity you get a curve that is normally not flat and usually upward sloping. The shape of this curve is called the 'term structure of interest rates' and the curve itself is called a yield curve. Yield curves are not always upward sloping. At times they are flat, or humped, or even downward sloping. What we would like to know is why they exist and why the shape changes. There are three theories that attempt to answer these questions. These are the "expection theory", the "liquidity preference theory", and a combination of the two. Expectation theory Long term rates are expected future short term rates. Upward sloping curves mean that we expect rates to rise. investors will move to cash bidding up the price (and bid down the yield) of short term instruments and bidding down the price (and up the yield) of long term bonds. Downward sloping curves mean that investors expect rates to fall. They will move to long term bonds bidding up the price (and bid down the yield) of long term bonds and bidding down the price (and up the yield) of short term instruments. Flat curves mean that investors do not foresee changes in interest rates. No explanation of humped curves exists in this theory
Liquidity preference theoryPeople would rather consume now than later. To give up consumption rights they will demand a liquidity premium. The longer they have to wait the higher the liquidity premium. This explains upward sloping yield curves. No explanation for downward sloping and flat curves exists in this theory. These curves are called 'anomalies' by Liquidity Preference theorists.
Combined theoryBoth theories are correct and these forces interact to produce yield curves of different shapes. When expectations are for higher interest rates in the future both forces push the yield curve up and produce a strong upward sloping yield curve. When interest rates are expected to fall expectation forces oppose liquidity preference forces and may produce a variety of yield curves including downward sloping and humped. The shape depends on the relative magnitudes of these forces. |
