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Wednesday, November 30, 2005

Econbrowser: Inverted yield curve edges closer

This one's for the Finance and Economics Professors among my readers.

James Hamilton at Econbrowser is discussing how the an inverted yield curve yield curve is related to recessions (for those not familiar with the term, an inverted yield curve describes the pattern where rates on longer-term debt instruments are lower than those on shorter term instruments). He starts out by explaining the Expectations Hypothesis:
A very simple model known as the expectations hypothesis of the term structure of interest rates posits that investors don't particularly care which maturity they invest in, and as a result would always bid prices for different maturities so that the expected yield from rolling over securities of different maturities is identical.
He then goes on to explain how the Expectations Hypothesis doesn't fully explain the shape of the yield curve, and closes with some thoughts on how changes in the yield curve are related to expected recessions.

All in all, a good piece to give to your class for discussion the next time you teach about the term structure of interest rates. Click here for the whole thing.

Updated 11/30: Kash at Angry Bear also has a few thoughts on the subject, and a nice non-technical explanation of why the inverted yield curve is often followed by a recession.

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