"The reason for the historical relationship between the slope of the yield curve and the economy’s performance is that the long-term rate is, in effect, a prediction of future short-term rates"
This is Krugman working with expectation theories. My claim is simple, long term rates represent what investors learn about long term events, as knowledge of long term events rises above uncertainty. The yield curve will be composed of stochastically independent estimations, orthogonal.
The issue came up because the FRB in Cleavland came out with an update of their predictions based on yield curve shape. The Krugman expectations view is that the yield curve is not functioning properly, as a predictor, because of the zero interest bound. Investors are betting that long term rates must rise because short term rates cannot drop further. Hence, like an option trade, there are few choices where short term rates can go.
The recent rise in ten and twenty year rates occurred because investors make choices as the restructuring of our economy unfolded, they had to make asset allocations as long term trends became clearer. The "option trading" on short term rates is suffering very low volume, investors are simply not betting o the short term yet. Look at the number of short term traders sitting out the market, as Zero Hedge identified over and over.
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