In a normal yield curve environment, long-term interest rates are higher than short-term interest rates. Investors expect to be compensated with higher returns when they lend money for a longer period since they are exposed to a higher default risk. The normal or positive yield curve is said to be upward sloping, as shown in the following graph:
In certain economic conditions, the yield curve can be inverted. Long-term interest rates are lower than short-term interest rates. Such a condition occurs when the supply of money is tight. Investors are willing to forgo long-term gains to preserve their wealth in the short-term. During periods of high inflation, where the inflation rate exceeds the rate of coupon interests, negative interest rates may be observed. Investors are willing to pay in the short-term just to secure their long-term wealth. The inverted yield curve...