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We have already proposed a general principle of finance – that lesser liquidity demands greater reward. That being the case, longer-term instruments should always bear a higher interest rate than short-term ones. This is not always true. Long-term rates can be the same as, or lower than, those of short-term instruments.

A curve can be drawn which links the different levels of rates with the different maturities of debt. If long-term rates are above short-term ones, this is described as a positive or upward-sloping yield curve. If short-terms rates are higher, the curve is described as negative or inverted.

What determines that shape of the yield curve? The three main theories used to explain its structure are the liquidity theory, the expectations theory and the market-segmentation theory.

The liquidity theory, which has already been outlined, states simply that investors will demand an extra reward (in the form of a higher interest rate) for investing their money for a long period. They may do so because they fear that they will need the funds suddenly but will be unable to obtain them, or they may be worried about the possibility of default. Borrowers (in particular, business) will be prepared to pay higher interest rates in order to secure long-term funds for investment. Thus, other things being equal, the yield curve will be upward-sloping.

The expectations theory holds that the yield curve represents investors’ views on the likely future movement of short-term interest rates. If one-year interest rates are 10 per cent and an investor expects them to rise to 12 per cent in a year’s time, he will be unwilling to accept 10 per cent on a two-year loan. It would be more profitable for him to lend for one year and then re-lend his money at the higher rate. A two-year loan will therefore have to offer at least 11 per cent a year before the investor will be attracted. Thus if interest rates are expected to rise, the yield curve will be upward-sloping. If investors expect short-term interest rates to fall, however, they will seek to lend long-term. That will increase the supply of long-term funds and bring down their price (i.e. long-term interest rates). Thus the yield curve will be downward-sloping.

What determines investors’ expectations of future interest-rate movements? Much may depend on future inflation rates. If inflation is set to rise, then price rises will absorb much of an investor’s interest income. So investors will demand higher rates when they think inflation is set to increase.

Keynes constructed a more elaborate theory which depended on the yield of securities. If people expect interest rates to rise, Keynes argued, they will hold on to their money in the form of cash, in order to avoid capital loss. But if they expect rates to fall, they will invest their money to profit from capital gains. Of course, this principle applies to bonds rather than to interest-bearing accounts. As we have seen, if interest rates rise, the price of previously issued bonds falls until investors earn a similar yield from equivalent bonds. Thus a bond investor who expected rates to rise will sell his bonds before the rise in rates and the resultant fall in the bond price occurs. The investor will hold the funds in the most liquid form available so that he can reinvest them as soon as rates rise. If the same investor expects interest rates to fall, the will hold on to the bonds because their price will rise as rates fall.

The third theory of the yield curve is the market-segmentation theory. This assumes that the markets for the different maturities of debt instruments are entirely separate. Within each segment interest rates are set by supply and demand. The shape of the yield curve will be determined by the different results of supply/demand trade-offs. If a lot of borrowers have long-term financing needs and few investors want to lend for such periods, the curve will be upward-sloping. If borrowers demand short-term funds and investors prefer to lend for longer periods, the curve will be downward-sloping.