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Draw a graph of a hypothetical, slightly inverted yield curve in the US Treasuries market (interest...

Draw a graph of a hypothetical, slightly inverted yield curve in the US Treasuries market (interest rate on the vertical or y axis). Use the expectations theory to describe (briefly) what this curve implies about market participants’ forecast for short term Treasury bond yields. Are there other economic forecasts implied by this forecast of short-term yields?

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Answer #1

An inverted yield curve is shown below.

The expectations theory says that forward rates in current long-term bonds are closely related to the bond market's expectation about future short-term interest rates. An inverted yield curve means that short term treasury bond yield are expected to be higher than long term yields.

Extending the outlook, interest rates are closely related to expected long term economic performance and growth. So an inverted yield curve also implies that investors are foreseeing a sluggish economic growth or recession.

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