Suppose the economy has an inverted yield curve. According to the liquidity premium theory, which of the following interpretations could be used to explain this?
A) Interest rates are expected to rise in the future.
B) Investors expect an economic slowdown.
C) Investors are indifferent between bonds with different time horizons.
D) The term spread has increased.

Question

Quizplus · Accepted Answer

According to the liquidity premium theory, a yield curve inversion implies that investors expect an economic slowdown. This is because long-term bonds would be in greater demand as investors anticipate interest rates falling in the future, which would reduce the value of short-term bonds. This increased demand for long-term bonds leads to a decrease in their yields, hence an inverted yield curve.

Suppose the Economy Has an Inverted Yield Curve