Question

Assume that:

i) investors and borrowers expect the economy to contract and inflation to decline

  ii) investors seek a lower liquidity premium from longer investments

iii) bond markets are partially segmented and the US Treasury currently has a preference for borrowing in short-term bond markets.

Explain how each of these forces would affect the term structure of interest rates, holding other factors constant. Then explain the effect on the term structure overall.

Answer 1

The term structure of interest rates is also known as yield curve. This curve is plotted between the interest rates offered by similar kinds of bonds with different maturities. The yield or interest rate or coupon rate is taken in Y-axis and the time to maturity is taken in X-axis. This graph shows the relationship between yield and maturity but also hints about the health of the economy.

The bond in absence of credit risk possesses an interest rate risk which is caused due to expected future inflation rate fluctuations.

i) As mentioned in the case, the economy is going to contract for which the inflation will be declining indicates that there wouldn't be much difference between the yield of short-term and long-term bonds. The inflation is the worst enemy of bond because it erodes the value of future cash flows, so higher the inflation means higher the yield will rise across the yield curve. And when the economy contracts it is seen that the yield curve generally flattens. Which means less difference in yield with an increase in maturity.

ii) Investors seek lower liquidity premiums for long-term instruments means that their overall required return has decreased for long-term instruments which would cause decline in the interest rate for long-term instruments that they used to have earlier. Which indeed will flatten the curve.

iii) Bond markets are partially segmented and the US Treasury currently has a preference for borrowing in short-term bond markets will increase the demand of the short-term bonds which will result in an increase in coupon rates of the short-term bonds. This will reduce the diffrence in the yield of long-term and short-term bonfds.

The overall effect on term structure or yield curve will be that the curve will get flatten or might get inverted as the short-term required return rises due to multiple reasons as discussed above. If the interest rate of short-term rises more than the long-term interest rate then the curve will get inverted and the economy might experience a recession in near future.