Question

17. If a yield curve looks like the one shown in the figure below, what is the market predicting about the move- ment of future short-term interest rates? What might the yield curve indicate about the market's predictions for the inflation rate in the future? Yield to Maturity Term to Maturity

Answer 1

Yield curve shows relationship between maturity periods on horizontal axis and yield percentages on vertical axis. The curve is increasing in the future periods; it means long-term bonds give higher returns compare to short-term bonds. Bond yield and market price of bond have an inverse relationship – if one increases the other decreases. Again, the market price of bond and the market interest rate have an inverse relationship. Therefore, as per the graph the increasing yield decreases the market price of bond that increases market interest rate. Future rates would increase.

Inflation and market interest rate have an inverse relationship. Since market interest rate increases as above, people may not have enough money in their hands for additional spending; it decreases inflation. Therefore, the increasing yield curve decreases the rate of inflation.

Implication: The economy is in the phase of expansion to contraction in future. It is understood through the increasing interest rate, which decreases the inflation rate. Unemployment could be an issue in future, because inflation and unemployment have an inverse relationship. The government should look forward to the ultimate tolerance of unemployment rate; if it is reached, an expansionary policy must be taken to boost up the economy again.