In core reading it is mentioned that “steep yield curve indicates higher credit premium”. I’m thinking that steep yield curve indicates that economy’s going to do well in future, therefore defaults will be low, so credit premium demanded by investors should be low right? Where am I thinking wrong?
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Not necessarily. To being with, the shape of the yield curve can have multiple interpretations.
Yield Curve is mostly looked upon from the Bond market participants’ perspective. In a way, the same incorporates Credit Premium (mostly), Liquidity Premium, Maturity Premium, etc. at the longer ends. A Steep YC indicates a higher credit premium.
If the Economy is going to do well in the future (Long Term), so that means, at the longer ends, credit premiums will be low and adding the same to Rf, the Long Term Yields will be lower which in turn might make the shape of the YC to be flattish.