What broader market condition can a flat yield curve potentially signal?
Group of answer choices
A Economic stability.
B Economic recession.
C Surge in consumer spending.
D Expansionary monetary policy.
E Decline in corporate profits.
The correct answer and explanation is:
The correct answer is: B Economic recession.
A flat yield curve occurs when the interest rates on short-term and long-term government bonds are very close to each other. Normally, long-term bonds have higher yields than short-term bonds because investors expect to be compensated for the increased risk of holding debt for a longer period. When the yield curve flattens, it means this difference shrinks significantly.
This flattening can signal economic recession because it reflects investor expectations about future economic growth and interest rates. When investors become pessimistic about the economy’s future, they anticipate slower growth or even contraction. In such cases, long-term interest rates tend to fall as demand for long-term bonds increases. Investors seek the safety of long-term government bonds, pushing their prices up and yields down. Meanwhile, short-term rates may stay the same or even rise if the central bank maintains or raises policy rates.
The flat yield curve suggests that investors do not expect higher inflation or stronger economic growth in the future, which is often a precursor to an economic slowdown or recession. Historically, a flat or inverted yield curve (where short-term rates are higher than long-term rates) has been a reliable predictor of recessions in many economies.
In contrast, an upward sloping yield curve, where long-term rates are higher, indicates positive expectations for growth and inflation. Therefore, a flat yield curve signals uncertainty or negative sentiment about the economy’s outlook, making it a warning sign for potential recession.
The other options like economic stability, surge in consumer spending, expansionary monetary policy, or decline in corporate profits do not directly correspond to what a flat yield curve typically signals. Economic stability and surge in consumer spending usually correlate with a normal upward-sloping yield curve, while expansionary monetary policy tends to lower short-term interest rates and steepen the curve. Decline in corporate profits may influence economic conditions but is not specifically signaled by a flat yield curve.
In summary, a flat yield curve is generally seen as a signal that the market expects slower economic growth or recession ahead.