53.10
10. The February 3rd WSJ contained this picture of the yield curve. It is inverted (yields for long-term bonds are lower than for short-term bonds). We talked about 3 factors that drive the yield curve and pointed-out that two of those factors tend to result in an upward-sloping (non-inverted) yield curve. The US Treasury announced on Feb 2nd that it was going to issue far fewer long-term bonds than in the past. Imagine your boss (either a bond trader or a chief financial officer trying to plan for a corporate debt issue) asks you what is going on. Identify which of the three factors driving the yield curve the Treasury's decision impacted and why it resulted in an inverted yield curve. [6 pts]
In class, we talked about how:
- Investors' expectations
- Higher risk / lower liquidity for longer maturities
- Higher demand for funds than supply of funds at long maturities
all impact the shape of the yield curve.
The first of these factors could make it slope up or down, depending on which way expectations go. However, #2 and #3 tend to add a premium onto longer-term rates, making the normal shape of the yield curve upward sloping. When the Treasury announced that it was going to issue fewer long-term bonds, it cut the demand for long-term funds considerably. Thus, if the demand for long term funds falls more in line with the supply of long-term funds, that supply/demand premium from point 3 goes away and the curve begins to invert.