Higher future rates of expected inflation will result

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Unformatted text preview: tions about future interest rates and inflation. Higher future rates of expected inflation will result in higher long-term interest rates; the opposite occurs with lower future rates. This widely accepted explanation of the term structure can be applied to the securities of any issuer. For example, take the case of U.S. Treasury securities. Thus far, we have concerned ourselves solely with the 3month Treasury bill. In fact, all Treasury securities are riskless in terms of (1) the chance that the Treasury will default on the issue and (2) the ease with which they can be liquidated for cash without losing value. Because it is believed to be easier to forecast inflation over shorter periods of time, the shorter-term 3-month U.S. Treasury bill is considered the risk-free asset. Of course, differing inflation expectations associated with different maturities will cause nominal interest rates to vary. With the addition of a maturity subscript, t, Equation 6.3 can be rewritten as RF t k* IPt (6.4) CHAPTER 6 FOCUS ON PRACTICE Interest Rates and Bond Valuation Watch Those Curves! Why do financial institutions, individual investors, and corporations that need to issue debt pay close attention to the yield curve, looking for any changing patterns? Because the shape of the yield curve—a chart of the gap between short- and long-term interest rates—has been an excellent predictor of future economic growth in the United States. In general, sharp upward-sloping (“normal”) yield curves signal a substantial rise in economic activity within a year. Downward-sloping (“inverted”) yield curves have preceded every recession since 1955 (although recession did not follow an inverted curve in the mid-1960s). The yield curve is based on the manner in which rates on different debt maturities are set. The marketplace determines long-term interest rates, which are tied to various economic factors, such as investors’ views on the outlook for growth and for inflation. Because the Federal Reserve sets shortterm rates, it can direct the pace of economic activity by managing the diff...
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