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Homework answers / question archive / In 2006, an ECB report stated that despite an overall increase in euro area long term bond yields, the euro area yield curve flattened during the year
In 2006, an ECB report stated that despite an overall increase in euro area long term bond yields, the euro area yield curve flattened during the year. This is mirrored in the decline of the “term spread,” which is measured by the difference between the yield on a ten-year government bond and a three month EURIBOR. During 2006, there was almost a 50 basis point decline in the term spread, reaching to almost 30 basis points by the end of the year. Typically, long-term interest rates are above short-term rates. In terms of the Fisher effect, what would that pattern say about expected inflation and/or the expected future real interest rate?
Since there is a decline in the term spread between long term and short term interest rates, this means that the investors are not inclined towards wanting higher interest rates for the future periods. As is mentioned in the passage, the overall long term yeild increased but the term spread reduced, this means that there is an overall incerease in the interest rates regardless of whether the asset is a long term or a short term asset. This can be because of the overall economic prosperity.
According to the Fisher effect, this reduction in the term spread which means investors are being indifferent between their short term and long term interest rates, it shows that in the long term also, the investors are not expecting a higher inflation rate and hence they are ready to invest even if the long term interest rates are not particularly higher than the short term interest rates.
