Question

Explain how different theories explain term structure of interest rates and how the Federal Reserve can conduct policies to impact interest rates.

Answer 1

Term structure of interest rates, commonly known as the yield curve, depicts the interest rates of similar quality bonds at different maturities.

Essentially, term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. When graphed, the term structure of interest rates is known as a yield curve, and it plays a crucial role in identifying the current state of an economy. The term structure of interest rates reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions.

In general terms, yields increase in line with maturity, giving rise to an upward-sloping, or normal, yield curve. The yield curve is primarily used to illustrate the term structure of interest rates for standard U.S. government-issued securities. This is important as it is a gauge of the debt market's feeling about risk. The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt. (Yield curve rates are usually available at the Treasury's interest rate web sites by 6:00 p.m. ET each trading day),

The term of the structure of interest rates has three primary shapes.

1. Upward sloping—long term yields are higher than short term yields. This is considered to be the "normal" slope of the yield curve and signals that the economy is in an expansionary mode.
2. Downward sloping—short term yields are higher than long term yields. Dubbed as an "inverted" yield curve and signifies that the economy is in, or about to enter, a recessive period.
3. Flat—very little variation between short and long term yields. Signals that the market is unsure about the future direction of the economy.

• Term structure of interest rates, commonly known as the yield curve, depicts the interest rates of similar quality bonds at different maturities.
• The term structure of interest rates reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions.
• The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year and 30-year U.S.

This yield curve is considered the benchmark for the credit market, as it reports the yields of risk-free fixed income investments across a range of maturities. In the credit market, banks and lenders use this benchmark as a gauge for determining lending and savings rates. Yields along the U.S. Treasury yield curve are primarily influenced by the Federal Reserve’s federal funds rate. Other yield curves can also be developed based upon a comparison of credit investments with similar risk characteristics.

Most often, the Treasury yield curve is upward-sloping. One basic explanation for this phenomenon is that investors demand higher interest rates for longer-term investments as compensation for investing their money in longer-duration investments. Occasionally, long-term yields may fall below short-term yields, creating an inverted yield curve that is generally regarded as a harbinger of recession.

The term structure of interest rates and the direction of the yield curve can be used to judge the overall credit market environment. A flattening of the yield curve means longer-term rates are falling in comparison to short-term rates, which could have implications for a recession. When short-term rates begin to exceed long-term rates, the yield curve is inverted, and a recession is likely occurring or approaching.

When longer-term rates fall below shorter-term rates, the outlook for credit over the long term is weak. This is often consistent with a weak or recessionary economy, which is defined by two consecutive periods of negative growth in the gross domestic product (GDP). While other factors, including foreign demand for U.S. Treasuries, can also result in an inverted yield curve, historically, an inverted yield curve has been an indicator of an impending recession in the United States.