Carlisle predicts that Country #3 will slip into a recession next quarter. She thinks it will be short-lived, lasting only 12 months or so, and considers the impact of such a recession on the performance of the country’s stocks and bonds.
-If Carlisle’s prediction about the economy of Country #3 is realized, the yield curve in Country #3 will most likely:
A.remain flat.
B.become upward sloping.
C.become downward sloping.
Solution
B is correct. The yield curve in Country 3 is currently flat (Exhibit 1), and Carlisle predicts a recession. During a recession, short-term rates tend to be lower because central banks tend to lower their policy rate in these times. However, the impact of monetary policy on longer-term rates will not be as strong because the central bank will usually be expected to bring short-term rates back to normal as the recession recedes. Thus, the slope of the yield curve will likely become upward sloping during the recession.
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Carlisle predicts that Country 3 will enter a recession next quarter.
The question asks how this recession will affect the yield curve.
Currently, the yield curve is flat, meaning short-term and long-term rates are similar.
During a recession, central banks typically lower short-term interest rates to stimulate the economy.
However, long-term rates are less affected because markets expect rates to return to normal after the recession ends.
This causes the yield curve to become upward sloping, with short-term rates lower than long-term rates.
Therefore, the answer is B: the yield curve will become upward sloping.