Term Structure and Default: April Fool’s

Paul Krugman does a nice job discussing the recent term structure and the competing hypothesis of why it is so steep:

As many people have noticed, the term spread — the difference between short-term and long-term interest rates — is very high. The last time I wrote about this, people were taking this as proof that the economy would recover soon. Now they’re taking it as bad news — as somehow suggesting fears of default. But there’s a reason for a high term spread that has nothing to do with either explanation. As I tried to explain last time, to a first approximation you can think of the long term rate as reflecting an average of expected future short-term rates. Short-term rates, in turn, tend to reflect the state of the economy: if the economy improves, the Fed will raise short-term rates, if the economy worsens, the Fed will cut. So long-term rates can be either above or below short rates. Except that now they can’t. If the economy improves, short rates will rise; but if it worsens, well, they’re already zero, so there’s nowhere to go but up. This implies that there has to be a positive term spread.

Paul continues by noting that the fear of default hypothesis would be reflected in higher inflationary expectations. Our graph, which reflects government bond rates for March 31, 2010, shows the term structure for nominal rates (blue) as well as for real rates (red). The difference (green) reflects the term structure with respect to expected inflation. Not only is expected inflation quite modest even as measured by the 30-year bond rates, the upward tilt of our green line is not as pronounced as the term structure for real rates.