The normal yield curve, also known as an upward-sloping yield curve, depicts the relationship between bond yields (interest rates) and their maturities, where longer-term bonds typically offer higher yields than shorter-term bonds. This slope reflects investors’ expectations, preferences, and risk assessments in financial markets. In Ghana’s context, the yield curve is influenced by factors such as Bank of Ghana’s monetary policy, inflation trends, and liquidity conditions in the banking sector, as seen in post-2019 banking cleanup scenarios where banks managed interest rate risks amid recapitalization efforts under the Banks and Specialized Deposit-Taking Institutions Act, 2016 (Act 930). Below, I explain the slope using the Liquidity Preference Approach and the Risk Approach, drawing on practical implications for Ghanaian financial intermediaries like GCB Bank or Ecobank Ghana, which actively manage treasury portfolios to balance liquidity and profitability.

Liquidity Preference Approach

The Liquidity Preference Theory, developed by John Maynard Keynes, posits that investors have a natural preference for holding short-term, liquid assets over long-term ones due to uncertainty about future interest rates and the need for cash. This preference creates a premium that must be paid to entice investors to hold longer-term bonds, resulting in an upward-sloping yield curve.

• Key Assumptions and Mechanism:
  • Investors view short-term bonds as more liquid because they mature quickly, allowing reinvestment or access to funds without significant price volatility. In contrast, long-term bonds tie up capital for extended periods, exposing holders to greater uncertainty (e.g., potential interest rate changes that could devalue the bond if sold early).
  • To compensate for this “illiquidity,” issuers must offer higher yields on longer-maturity bonds. This liquidity premium increases with maturity, causing the yield curve to slope upward.
  • The theory integrates money demand: People hold money for transactions, precautions, and speculation. Speculative demand rises when interest rates are expected to increase, making short-term holdings preferable.
• Explanation of the Normal Yield Curve Slope:
  • Under normal economic conditions (e.g., moderate growth and stable inflation), the yield on a 1-year Ghanaian Treasury bill might be 15%, while a 10-year government bond yields 20%. The difference (5%) represents the liquidity premium demanded by investors for forgoing liquidity.
  • If future short-term rates are expected to remain stable, the curve would be flat per the Pure Expectations Theory. However, liquidity preference adds an upward bias, as investors require extra compensation for maturity risk, even if rates are not expected to rise.
• Practical Examples in Ghana:
  • During the 2022-2023 Domestic Debt Exchange Programmed (DDEP), Ghanaian banks faced liquidity pressures from high inflation (peaking at over 50% in 2022) and panic withdrawals. Investors preferred short-term instruments like 91-day T-bills for quick liquidity, pushing yields on longer bonds higher to attract holdings. This aligned with BoG’s Liquidity Risk Management Guidelines, where banks like Stanbic Bank Ghana hedged by diversifying into short-term assets to minimize opportunity costs.
  • In a stable post-DDEP recovery phase (as of 2025), the BoG’s monetary policy—targeting inflation below 10%—reinforces this slope, as investors demand premiums for long-term exposure amid forex volatility under the Payment Systems and Services Act, 2019 (Act 987).

This approach highlights how behavioral factors drive the curve’s shape, emphasizing caution in treasury management to avoid mismatches, as per Basel III-adapted standards in Ghana.

Risk Approach

The Risk Approach, often encompassing elements like the Market Segmentation Theory or Interest Rate Risk Premium, focuses on the inherent risks associated with longer maturities, such as interest rate risk, default risk, and reinvestment risk. Investors demand higher yields for these risks, leading to an upward-sloping normal yield curve. This is distinct from liquidity preference but complementary, as it underscores objective risk factors rather than subjective preferences.

• Key Assumptions and Mechanism:
  • Longer-term bonds carry higher interest rate risk: If rates rise, bond prices fall more sharply for long maturities due to duration effects (a measure of price sensitivity).
  • Default risk may increase over time, especially in emerging markets like Ghana, where economic shocks (e.g., commodity price fluctuations) could impair government or corporate repayment.
  • Reinvestment risk is lower for long-term bonds (locked-in rates), but overall, the net risk premium rises with maturity, sloping the curve upward.
• Explanation of the Normal Yield Curve Slope:
  • In a normal environment, short-term yields are lower because risks are minimal—e.g., a 3-month bond has limited exposure to rate changes. Long-term yields incorporate cumulative risk premiums, creating the slope.
  • For instance, if the risk-free short-term rate is 10%, a 5-year bond might yield 14% (adding 4% risk premium), and a 20-year bond 18% (adding more for extended exposure). This reflects the term structure, where the curve slopes up to compensate for volatility.
• Practical Examples in Ghana:
  • Post the 2017-2019 banking sector cleanup, where banks like UT Bank collapsed due to liquidity and governance issues, surviving institutions (e.g., Access Bank Ghana) priced long-term loans higher to cover risks, mirroring the yield curve. BoG’s Capital Requirements Directive (CRD) mandates stress testing for interest rate risks, ensuring banks hold capital against potential yield curve shifts.
  • In 2024-2025, with Ghana’s Eurobond issuances and forex reserves stabilization, the risk approach explains why yields on 7-year bonds exceed those on 182-day T-bills, factoring in inflation risks and compliance with BoG’s Corporate Governance Directive 2018, which promotes prudent risk management to enhance profitability without excessive exposure.

In summary, both approaches explain the normal yield curve’s upward slope through compensation for liquidity forfeiture and risk-bearing, respectively. For Ghanaian banks, integrating these into asset-liability management (ALM) ensures resilience, as evidenced by BoG’s sustainable banking principles promoting diversified portfolios to mitigate curve-related risks. A practical recommendation is regular yield curve analysis using tools like duration matching, aligning with global standards like those from Barclays’ operations for comparative insights.