Question

Imagine that the yield curve is currently flat. The Treasury announces that they will no longer issue securities with maturities longer than two years. As a result, long-term government bonds will be refinanced using only relatively short-term debt. If the "market segmentation theory" of the yield curve is correct, what will happen to the slope of the yield curve as a result of this policy change? Explain briefly.

Explain the impact of the new policy on the yield curve, therefore you must compare it with the current policy.

Answer 1

The market segmentation theory states that there is no relationship between long term and short term interest rates.

And the interest rates are totally dependent on the supply and demand of bonds in the market.

Due to policy decision of only short term bonds being issued, the supply of short term bonds would increase and this would reduce the yield on these bonds. While the amount of long term bonds would decrease and hence the yields on these bonds would increase.

The yield curve would therefore slope upwards in a steep manner.

In the current policy, there is a fair distribution of short and long term bonds and hence the yield curve would be relatively flat. But with new policy, the short term bonds would be greater in supply and hence their yields would reduce. The long term bonds would be less in supply and higher in demand and thus would have higher yields. So yield curve would be upwards sloping.