Question

The cost of long-term borrowing is usually higher than the cost of short-term borrowing. The graph that shows the relationship between maturity and interest rates for U.S. Government’s borrowings (Treasuries) is called “term structure of the interest rates” or “the yield curve”. Shape of the yield curve is often used by economists to forecast future status of the economy

1. Discuss why long-term rates are usually higher than short-term rates (upward yield curve)

2. Discuss under what economic conditions long-term rates might not be higher than short-term rates (flat or inverted yield curve).

3. Go to http://www.bloomberg.com, brows various links on the site, find the yield curve for the day of your search, and

4. Interpret your observation of the yield curve

Answer 1

1]

Long term rates are usually higher than short term rates because investors demand higher yields for longer term bonds as compared to short term bonds. This is because longer term bonds are more risky for the bond investors, due to interest rate risk, inflation risk, and default risk. In other words, longer term bonds have higher risk due to their longer maturity, and hence their yields are higher than short term bonds.

2]

When the economy is about to enter a recession, the yield curve becomes flat or inverted.

This is because in a recession, investors sell stocks and buy bonds. Due to the higher demand for bonds, their prices rise, and yields fall. Further, the Fed may lower interest rates to spur demand. These factors lead to a condition where longer term bonds have lower yields than short term bonds.

3]

Treasury Yield Curve 3.5% N Treasury yield % wo 20Y Current Feb. 2019 + Feb. 2018

4]

The yield curve is flat/downward sloping upto 10-years maturity, and upward sloping from 10-years to 30-years maturity

This suggests that the economy is not going to enter a recession.