Suppose the economy has an inverted yield curve. According to the expectations hypothesis, which of the following interpretations could be used to explain this?
A) Interest rates are expected to fall in the future
B) Investors prefer bonds with less default risk.
C) Investors prefer bonds with less interest-rate risk.
D) The term spread is positive.

Question

Quizplus · Accepted Answer

The expectations hypothesis states that long-term interest rates are equal to the average of expected future short-term interest rates. If the yield curve is inverted, this means that short-term interest rates are expected to fall in the future. The inverted curve indicates that investors are demanding higher rates for short-term bonds than for long-term bonds because of an expected decrease in interest rates.

Suppose the Economy Has an Inverted Yield Curve