I am trying to reconcile the two difference of interpretations on the yield curve.
In Mock Exam 2010 Qns 4(answers), it mentioned that the steepening of the yield curve indicates a expanding economy , vice versa flattening means recession.
In Book 6(Monitoring and Rebalancing) 2.2.4 Yield Curve and inflation( Paragraph 2)
It mentioned that
1)Yield curve tends to become steeply upward sloping during recession
2)Flatten in the course of expansion
3)Downward sloping before and impending recession
I can agree with 3) but 1) and 2) seems to conflict with earlier topics.
The reason given in book 6 is that investor demand greater rewards during bad times(steepning yield curve)…this comes into conflict with the idea that
“A steepening yield curve typically indicates investor expectations for 1) rising inflation 2) stronger economic growth (since improving growth causes the demand for longer-term capital to increase even as the Fed maintains a low-rate policy).”
Think of it in terms of short rates-monetary policy, long rates-GDP, inflation growth expectations. Expansion, short rates low per the fed expansionary policy, long term expectations of gdp growth and inflation will be higher. Recession, short term rates have risen because of monetary policy restraining inflation and long term growth lowered per expected gdp growth and inflation. Also consider capital moves from stocks to bonds raising bond prices lowering yields.
My understanding is that during expansion yield curve is positively steep (low short rates due to easy monetary policy, higher longer rates due to lack of demand from investors as they go for stocks more that for bonds). When economy slows down yield curve flatterns (short rates increase as monetary authorities recognize overheating and step in and longer rates decrease due to increased prices=higher demand) and then, yield curive turns into downward sloping througout recession.
I think this is one of the conflicting areas of CFA. The understanding of upward sloping yield curve indicates the economy at the expansionary phase is CONSISTENT with LOS 17 “Capital Market Expectations”
But in Book 6 LOS 33 it states a scenario where 2.2.4 Yield Curve and inflation( Paragraph 2)
Yield curve tends to become steeply upward sloping during recession because investor demand greater rewards during bad times(steepning yield curve)
I guess for the exam we just have to take notice which LOS in particular before answering the question.
Think about what the yield curve implies vs. what the current environment is; or, what the current environment is according to the yield curve and what the next likely economic stage will occur.