Interest-rate risk is gauged by the difference between long- and short-term Treasury rates, as measured by the yield curve. The greater the difference, or the steeper the yield curve, the higher are expected future interest rates – reflecting elevated budget deficit or inflation risks. Credit risk, on the other hand, is gauged by the difference between corporate and Treasury rates of comparable maturity, or corporate spreads. Wider corporate credit spreads reflect greater perceived risk of corporate defaults. Generally speaking, wide credit spreads or a steep yield curve are associated with periods of economic uncertainty. An extreme case occurred during the financial meltdown at the end of 2008 with both credit spreads and the yield curve’s steepness spiking as corporate rates rose sharply while Treasury rates fell with short-rates falling much more than long-rates.
The declining steepness of the yield curve, narrowing credit spreads and rapid rise of equity prices over the last few years largely reflect an extremely accommodative Fed monetary policy including numerous QEs (ballooning its balance sheet) – which has greatly reduced perceived risk. Going forward, however, a repricing of risk to more normal levels may reverse these trends along with rising rates.
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