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Yield curves and interest rates –
St. Louis Federal Reserve website
The yield curve is a graph of the term structure of interest rates, which is the
relationship of yield and maturity for securities of similar risk. When we
think of the yield curve we typically think of the Treasury yield curve, as
found each day in financial publications like the Wall Street Journal. The
yield curve’s shape and level changes due to a variety of monetary,
economic, and political factors.
The Federal Reserve Bank of St. Louis website (http://www.stls.frb.org) is
a useful site for obtaining actual economic and monetary data. To access
information from the Federal Reserve, you will be using FRED (the Federal
Reserve Economic Database). From this web page, click on the link to FRED
II  (Federal Reserve Economic Data), and then select “Interest Rates” from
the list of database categories. On this page and those that follow, you will
find links to all of the information needed for this cyberproblem. Upon
finding the appropriate interest rate series, click on “View Data” to find the
value in a particular month.
a.
Construct four distinct Treasury yield curves using monthly interest
rate data for February of the years 1982, 1988, 1993, and 1998. Use
the Constant Maturity Interest rates for maturities of 3-months, 6months, 1-year, 5-years, 10-years, and 30-years.
For this problem, we will access the Constant Maturity Rates
for each of the given maturities and pull data from the
database that corresponds with our scope of data. We will be
concerning ourselves with only rates from February 1982,
1988, 1993, and 1998. The results of that search yield the
following data set:
Security
Maturity
3-month T-bill
6-month T-bill
1-year T-bill
5-year Tbond/note
10-year Tbond/note
30-year Tbond/note
February
1982
14.28
14.81
14.73
February
1988
5.84
6.21
6.64
February
1993
2.99
3.16
3.39
February
1998
5.23
5.27
5.31
14.54
7.71
5.43
5.49
14.43
8.21
6.26
5.57
14.22
8.43
7.09
5.89
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b.
Examine the yield curves you have constructed. Knowing what the
components of the 3-month Treasury bill are, what could explain the
large variation in the 3-month risk-free rate over the different time
periods?
We know that rRF,T-bill = r* + IP; the 3-month risk-free rate is
composed of a real rate of return and an inflation premium.
The real rate of return does change, but usually not much and
not rapidly. The dramatic change in rRF over these different
time periods can be attributed to changes in investors' inflation
expectations. Investors require compensation for higher
expected inflation in the form of a higher interest rate. Thus,
when expectations of the rate of future inflation change, we
see changes in the risk-free rate.
c.
(a) Contrast the slopes of the February 1982 yield curve with that of
February 1993. What do we call a yield curve that possesses the shape
of the 1982 yield curve? (b) Why might the 1982 yield curve be
downward sloping? What does this indicate? (c) What does the 1993
yield curve say about long-term versus short-term interest rates?
The February 1982 yield curve is inverted or "abnormal". It has
a slight downward slope indicating that long-term interest
rates were slightly lower than short term interest rates at that
point in time. One interpretation based on Expectations theory
is that investors and market participants expected lower
inflation in the future and thus required a lower long-term
inflation premium (IP) than short-term inflation premium. The
view that long-term securities are riskier than short-term
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securities is consistent with the Liquidity Preference theory.
We then expect long-term rates to normally be higher than
short-term rates. This normal relationship may have been at
least temporarily displaced and lenders did not require a larger
risk premium for lending long-term as opposed to short-term.
d.
Contrast the yield curves of 1993 and 1998. Notice that the 1998 yield
curve is almost flat, it has very little slope, while the 1993 yield curve
has a very steep slope. What could account for this difference in
slopes?
Once again, expectations theory and liquidity preference theory
could be used to help explain the difference. This answer
focuses on expectations theory. In 1993, short-term interest
rates declined to levels not seen in decades, possibly indicating
very low expected short-term inflation. While actual inflation
had dropped significantly, perhaps investors believed that low
inflation was not likely to persist for long and thus rates for
Treasury maturities five years and beyond were much higher.
In February 1998 long-term rates had declined 120 basis points
(1.20%) but short-term rates had risen by over 200 basis
points (despite low inflation). A "flat" yield curve, where
short-term rates are similar to long-term rates, is often
associated with the peak of a business cycle. One could argue
that investors were more confident that a low inflation
environment would persist for awhile but that conditions in the
short-term market were markedly different than they were in
February 1993.
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