Question

US TREASURY YIELD CURVES 3.5 3 2.5 2 1.5 ܝܝܕ 0.5 0 1 mo 3 mo 6 mo 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 20 yr 30 yr --- Yields on 14th Dec 2016 Yields on 14th Dec 2017 Based on the above chart, provide answers to ALL the following questions: a) What trade, in terms of buying and selling short-term and long-term securities, should a trader have put on to take advantage of the yield curve shift between 2016 and 2017? 2 marks b) Suppose on 14th December 2017 the US Treasury 2-year note auction went particularly badly. What effect would this have had on the shape of the 14th December 2017 yield curve? 1 mark c) The US Treasury yield curve flattened between 2016 and 2017 (as shown in the diagram), what did this imply about short-term rates between 2016 and 2017 and expectations of future economic activity at that time? 2 mark d) Where would off-the-run' US Treasury bonds trade in relation to 'on-the-run' bonds and why?' 2 marks e) To finance Covid-19 government expenditure, if the US Treasury issues significantly more 30-year bonds than any other maturity, what will this likely do to the shape of the yield curve?

Answer 1

a. At the start of 1 year period i.e. from 14th December 2016, the investors would prefer to park their securities in short term bonds as they would expect the log term yield to increase even further ast this time.

With the passage of time the difference between yields on short term bonds and long term bonds starts declining and investors start to park their funds in long term bonds expecting a recession in short term.

b. This would mean that in 2 year term investors are expecting a transition in economy from good to bad which would have led to flattening of the yield curve around that period of time.

c. As can be seen that the curve flattened nearly around 2-year maturity bonds, signalling that investors are expecting an economic transition around that period of time and thus have made investors wary of the short term bonds as well. This led to a decrease in difference of yields between 1 year and 2year maturity bonds.

d. The difference in yields between on the run and off the run treasury bonds will decrease due to an expected downturn in the economy and a financial crisis.