CHAPTER 6 Interest Rates and Bond Valuation 269In other words, for U.S. Treasury securities the nominal, or risk-free, rate for a
given maturity varies with the inflation expectation over the term of the security.^5EXAMPLE The nominal interest rate,RF, for four maturities of U.S. Treasury securities on
March 15, 2002, is given in column 1 of the following table. Assuming that the
real rate of interest is 1%, as noted in column 2, the inflation expectation for each
maturity in column 3 is found by solving Equation 6.4 forIPt. Although a 0.81%
rate of inflation was expected over the 3-month period beginning March 15,
2002, a 2.55% average rate of inflation was expected over the 2-year period, and
so on. An analysis of the inflation expectations in column 3 for March 15, 2002,
suggests that at that time a general expectation of increasing inflation existed.
Simply stated, the March 15, 2002, yield curve for U.S. Treasury securities shown- Although U.S. Treasury securities have no risk of default or illiquidity, they do suffer from “maturity, or interest
rate, risk”—the risk that interest rates will change in the future and thereby affect longer maturities more than
shorter maturities. Therefore, the longer the maturity of a Treasury (or any other) security, the greater its interest rate
risk. The impact of interest rate changes on bond values is discussed later in this chapter; here we ignore this effect.
In Practice
Why do financial institutions, indi-
vidual investors, and corporations
that need to issue debt pay close
attention to the yield curve, looking
for any changing patterns? Be-
cause the shape of the yield
curve—a chart of the gap between
short- and long-term interest
rates—has been an excellent pre-
dictor 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 re-
cession did not follow an inverted
curve in the mid-1960s).
The yield curve is based on
the manner in which rates on dif-
ferent 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 short-
term rates, it can direct the pace of
economic activity by managing the
differences between the two ends
of the interest rate spectrum. Most
periods of flat or inverted yield
curves occur when the Federal Re-
serve increases short-term rates,
tightening monetary policy to con-
trol inflation. These higher rates
curtail business growth because
savers pull money out of long-term
investments such as stocks and
bonds and put it into lower-risk
savings vehicles. When short-term
rates are low, people switch
money from liquid investments
such as money market accounts
into long-term investments, fueling
economic growth.
This proved true in 2001. An
inverted yield curve from July 2000
to early January 2001 triggered the
slowdown in economic activity. In
January the Federal Reserve cut
the federal funds rate (the rate on
loan transactions between com-
mercial banks) to stimulate the
economy but wasn’t able to pre-
vent the recession that began in
March 2001. The Fed cut short-term rates 10 more times in 2001—
a record for cuts in one year—to
bring the “fed funds” rate from 6.5
percent to 1.75 percent, the lowest
level since 1961. Long-term U.S.
Treasury securities outperformed
shorter maturities as institutional
and individual investors shifted
their portfolios to longer maturities,
betting that the curve would return
to its more normal upward slope as
the Federal Reserve rate cuts took
effect. By December 2001 the
spread between long-term and
short-term Treasury securities was
about 2.5 points. As the yield curve
turned strongly positive, econo-
mists predicted a short recession
with a strong recovery in 2002.
Sources:Adapted from Peronet Despeignes,
“Fed Cuts Rates by Quarter Point to 1.75%,”
FT.com(December 11, 2001), downloaded
from news.ft.com;Michael Sivy, “Ahead of
the Curve,” Money(August 2001), p. 51;
Michael Wallace, “The Fed Can’t Get Ahead
of the Curve,” Business Week Online
(November 5, 2001), downloaded from
http://www.businessweek.com;Linda Wertheimer,
“Analysis: Federal Reserve’s Latest Interest
Rate Cut,” All Things Considered (NPR),
November 6, 2001, downloaded from Electric
Library, ask.elibrary.com.FOCUS ONPRACTICE Watch Those Curves!