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10 20 2015 | by Victor Xing | Capital Markets

Why do yield curves flatten during period of deflation?

Period of deflation is usually associated with tightening money supply as investors and consumers become less averse to holding cash (please see an example of how cash hoarding will reduce inflation).  This ultimately reduces availability of credit to fund consumption and investments, thus lowering future growth and inflation.

Since long-term interest rates are correlated with future growth and inflation expectations (investors would demand higher yield to compensate for higher future rates, as higher rates dilute future payments of fixed income cash flows), lower growth and signs of deflation will push down long-term bond yields.  Assuming the Federal Reserve keeps policy on-hold, short-term interest rates will remain well-anchored, or mostly unchanged.  The combination of both effects will tighten the spread between short-term and longer-term bond yields, or in a more severe deflationary scenario, invert the yield curve.

Another example involves tighter FED policy – if the FED is on a war path to fight future inflation by hiking short-term rates, investors will similarly react to tighter future credit availability, slower future growth and higher risks of deflation.  In this case, investors will sell short-term Treasury notes and buy long-term Treasury bonds, because they don’t want to be holding short-maturity bonds in a policy tightening environment, and they want to hold long bonds as FED’s actions will lead to less growth and inflation.  As a whole, this will push up short-term interest rates and keep long-term rates unchanged or even lower, again tightening the spread between short-term and long-term rates.

Next article10 20 2015 | by Victor Xing | Economics

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