- dated maturities. to begin our discussion of the yield curve, it is worth revisiting the fisher equation, named after american economist irving fisher. the textbook equation states that nominal interest rates are equal to the required real rate of return on the funds invested, plus the expected inflation rate over the period of the investment. so it is clear that expected inflation plays an important role. the fisher equation can be modified to include a risk margin in the calculation of the nominal interest rate. the risk margin can reflect variability in the inflation rate ; it will in practice also take account of factors such as political and exchange rate risk. what will happen to capital market interest rates if investors decide they have to revise their expectations of future inflation upwards? investors in long - term assets who believe future inflation will be higher than initially expected will want to protect their real returns. as a result, they will demand higher nominal interest rates on longer - term bonds. in such a situation, one would expect the yield curve to steepen. can we say that if the yield curve steepens, it should necessarily be taken as a sign that the expected inflation rate in the future has risen? the answer to that is clearly no ; expected inflation is only one factor determining nominal interest rates. an increase in expected inflation should lead to a steepening in the yield curve, but - and this is a crucial point - a steeper yield curve does not necessarily signal a rise in expected inflation. the effect on the yield curve of factors other than expected inflation the yield curve is normally positively sloped ; in other words, the longer the duration of the investment, the higher the yields. the positive slope is explained, among others, by the premium on long - term bonds which is required to compensate for the greater risk in keeping paper with longer maturities. so, a positively sloping yield curve does not in itself tell us anything about inflation expectations or the economy. a crucial point in an analysis of the shape of the yield curve is that long bond yields are entirely market - determined while short - term interest rates are influenced by the monetary policy decisions of the central bank - which should, of course, also respect market forces. it follows that a steepening in the yield curve can be caused by monetary easing. such a steepening will happen when a reduction in short - term interest rates is not accompanied by a commensurate decline in long bond yields. why would long bond yields not follow short - term interest rates lower to the

policy action embedded in derivatives like the forward rate agreements, or fras, moved in sympathy, with the fra curve quickly pricing in not just an earlier but also a speedier pace of interest rate hikes by the reserve bank. part of this selloff probably represented more a re - pricing of risk at longer maturities – i. e. a higher “ term premium ” – rather than changes in actual expectations of future policy rates. it was indeed striking to see how strong the correlation had become, during the taper tantrum episode, between the longer ends of government yield curves in south africa and the united states, and this, despite the meaningful differences in economic and policy fundamentals between the two countries. the depth of domestic capital markets, which were able to absorb significant net sales of sa bonds by non - residents ( r68 billion from the beginning of may 2013 up to the end of last week, according to jse data ) also played a part. the renewed reduction in that “ term premium ” in major fixed - income markets in 2014, as policy guidance by the federal reserve seemed to reduce investors ’ uncertainties as to the future path of us rates, probably was a key factor towards the renewed decline in south african bis central bankers ’ speeches yields and the relative stabilisation in the rand since the end of january up until august 1. certainly, in terms of communication, central banks have progressed somewhat over the past couple of years, and particularly since the taper tantrum, the associated volatility in financial markets related to monetary policy communication, has also declined. the big question remains, however, how sustainable is the recovery that we are currently experiencing? or are we at risk, when us policy rates finally rise in 2015, assuming the median projections of both fomc members and market participants prove to be correct, of a repeat of the market snapback that we witnessed in 2013? it is not possible to answer this question with a great degree of confidence, for even if we assume that us policy tightening is largely “ priced ” into markets, the potential for a renewed rise in risk premiums exists, especially in light of the current low levels of implied volatility in a broad range of markets. nevertheless, several factors could usher in a different scenario from that of the “ taper tantrum ”. admittedly, the more the us economy continues on its “ healing ” path following the shock of the 2008 – 09 global financial crisis, the more eventual policy normal