consider the following numbers for the Federal government deficit and interest rates. Variable 1968 2019 Household...

consider the following numbers for the Federal government deficit and interest rates.

Variable	1968	2019
Household Debt to GDP (%)	45%	75%
Public Debt to GDP (%)	40%	105%
1 Year Treasury Bill Rate	5.90%	1.57%
5 Year Treasury Rate	5.80%	1.69%
10 Year Treasury Rate	5.70%	1.88%
CPI Inflation Rate	3.65%	1.70%

For fiscal year 2020, the Federal government was expected to run a deficit exceeding $1T. Now, with the various stimulus packages designed to alleviate the economic effects of the coronavirus epidemic, the 2020 deficit could hit 3 Trillion

A. How can interest rates be so low with such a high level of debt in the US?

B. What impact will the coronavirus outbreak/Federal deficits have on the yield curve in the coming months/years?

Solutions

Expert Solution

A. Interest rates are function of demand and supply of bonds. As the US government has high debt debts, selling bonds are one way to pay huge debt. At a high interest rate, demand for bonds is very low for purchase. Due to volatility in the financial asset market amidst the coronavirus pandemic, demand is shifting from high to low risk assets. High interest rate is associated with high return and high risk as well. Hence, Federal reserve has decided to keep interest rate so low to collet funds in order to meet high level of debt in US.

B. Slope of yield curve shows how future economic activities and interest rates are likely to change. In US yield on US treasury bond is at a record low. Yield on bonds is going down despite higher expected interest for future. Therefore, expectation on future movement of interest rate is not working actually. In the recessionary situation, low interest rate and low yield reflect basically the uncertainty and instability in the market in the absence of lack of response. Both short term and long-term interest rates such interest rate on mortgage have fallen. Thus, future outlook in the economy in terms of demand is very depressing. Hence, the impact on yield curve is likely to be even lower in coming months / years.

Rahul Sunny answered 1 year ago

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