Question

1. Suppose the Bank of Canada made an announcement that it would purchase up to $500 billion of long term Canada bonds over the following six month. What effect might this policy has on the yield curve? Explain in detail.

2. During the current economic crisis caused by the Coronavirus, what would you expect the yiedd curve to look like? Upward sloping, flat, or inverted.Explain in detail.

Answer 1

a.Purchasing long term Canada bonds over following six month will actually increase the demand of the long term bonds. Keeping the supply same, if the demand increases then the price of the traded bond will increase. An increase in the price of bond will push the yeild down in the longer end of the curve. This serves two purposes:

1. Supplying liquidity in the market

2. Re-alignment of the yeild spread between the shorter end & 10 year benchmark i.e. the differential decreases making the curve slope to decrease.

The curve is still upward sloping with a decresed slope as long end yield goes down.

b. The current economic crisis caused by Corona virus have a major effect on the debt market disturbing the yield curve. 10 year government security is considered as the safest and most easily tradable in the market. Due to the Corona virus, the complete market is fearful & running towards flight for safety. Investors try to sell the shorter end papers and buy the longer duration bonds for safety of money in long run. So suddenly the demand for 10 year government security has increased and there is too much supply of the shorter maturity papers as investors are dumping riskier assets for safety in treasury bonds. This pushs the prices up at long term bonds and prices down of short term papers. This increase in prices will force the yield to go down at long end and dumping of short term papers results in uptick at the short end of yield curve, thus causing the yield curve to invert. The inversion of the yield curve is a signal for soft landing of recession.