Rates/Yields Q

Which of the following statements regarding interest rates and yields is most accurate? A) An increase in short-term rates increases the yields on long-term bonds. B) An increase in short-term rates may increase or decrease the yields on long-term bonds. C) Short-term rates are independent of the yields on long-term bonds.

damn fixed income…Ill say B…

I am going with B as well.

B as well. The increase in short term rates could simply be a twist in the overall curve.

I think an increase in short-term rates will cause a slight decrease in yields on long-term bonds. Lack of answer choices …will go with B.

B

I can’t find hard enough questions in the Qbank for you guys anymore.

Hey Dwight, can you post the explanation for this one? thanks!

Your answer: A was incorrect. The correct answer was B) An increase in short-term rates may increase or decrease the yields on long-term bonds. Not a very enlightening explanation haha.

Can someone explain?

I think that the relationship in A usually holds true. That’s why I put A and got it wrong though so you might want to ask someone else haha. Short term rates go up, so the prices on long term bonds go down and the yield rises. I guess that it is possible for short term rates to go up and the yields to fall in some cases.

Increasing short term rates are usually a result of expectations of the Central Bank bumping rates. The Central Bank usually bumps rates to counter inflation. So the longer term expectations for inflation should fall. Declining longer term inflation expectations would result in lower longer term yields…no?

Dwight: We appreciate you posting all these questions. Thanks a lot.

I remember Schwser mentioned this point somewhere: 1. increase in near-term interest rate could make the yield curve shift up. 2. increase in near-term interest rate could be so high that slowdown economy activities, and therefore makes long-term interest rate decrease.

GetSetGo Wrote: ------------------------------------------------------- > Dwight: We appreciate you posting all these > questions. Thanks a lot. No problem sir.

Possible explanation could be: higher expected short-term interest rates (contracting monetary policy), you anticipate an economic slowdown and want to be in (traditional) non-cyclical asset classes (government bonds), everybody starts buying long-term govie bonds because they offer higher yields, their prices rise and their yields go down, the curve flattens. Or, apply preferred habitat theory, which explains all possible yield curve shapes =)

A was incorrect. The correct answer was B) An increase in short-term rates may increase or decrease the yields on long-term bonds.

I’m not saying A is correct, I was giving an example of how an increase in short-term rates can possibly drive down long-term bond yields. I probably should have included that the above example most likely occurs at or near the peak of contracting monetary policy, because if you anticipate that the central bank will have to reverse their policy and lower rates again soon (somebody above mentioned as a good reason lower inflation expectations, i.e. slowing economic activity or even recession), you would want to be in longer duration bonds. But you don’t want to start buying longer duration bonds when everybody else does, you would want to hold them when everybody else buys in order to make a profit. So you buy “early”, at or near the peak of hawkish central bank policy. An example of how “early” can go wrong has been PIMCO, the biggest bond investor in the world (no disrespect here). They were betting too early on a slowing economy, went into longer duration bonds and suffered relatively when interest rates didn’t go down as fast as they expected. Also, if you had a perfect positive correlation between short-term rates and long-term yields, you wouldn’t see the type of yield curve shapes that we see in the market. I guess A could be correct if you assumed that there is always a liquidity premium to holding longer maturities. But obviously, in reality that is not the case. To make it short, A just sounds too general and restrictive, implying almost that long-term yields always rise with short-term rates. I think it’s also helpful to not see the cause-and-effect as strictly one-way, i.e. yields determine prices because they are discount rates. It goes the other way as well, prices determine yields, too. Sorry for the long post…any comments are welcome.

Edit: add “…when short-term rates rise” after the part with perfect positive correlation.

GetSetGo Wrote: ------------------------------------------------------- > Dwight: We appreciate you posting all these > questions. Thanks a lot. Would just like to add that I agree with that! I went for A as well =(