I have got a question on the Portfolio Management ( Reading 46) Q10 practice problem p.484
Reading 46 p.484 Q10
During a recession, the slope of the yield curve for default-free government bonds is most likely to:
C become inverted
May i know why the answer is B please ?
Because what i have understand is that an inverted yield curve is often read as being a predictor of recession, so i think the answer should be C? As i think during the recession, they would demand more yield for short term bond than long term bond?
Before the recession, the yield curve is already inverted. The question is asking what will happen to the yield curve during a recession.
During a recession, the central bank will use the monetary policy to spur the economy (by reducing policy rates). And monetary policy has a bigger impact on short-term rates than on long-term rates (same concept is discussed in Fixed Income). So the short-term rates will drop faster than the drop in long-term rates, leading to a steepened yield curve.
When times are bad, people are willing to accept a lower yield in return for certainty (knowing they will have money in the future to spend). That explains why the yield on short-term bonds are lower in a recession. For longer-term bonds, they are a poorer hedge against bad economy (so investors will require a higher risk premium a.k.a higher yield).
During recession, central banks are likely to lower short term rates but long term rates are unlikely to reduce at same rate as the short term rates. That’s why the yield curve will be steeper during a recession.