6-4 The Term Structure of Interest Rates

The term structure of interest rates describes the relationship between long- and short-term rates.

The term structure is important to corporate treasurers deciding whether to borrow by issuing long- or
short-term debt and to investors who are deciding whether to buy long- or short-term bonds. Therefore,
both borrowers and lenders should understand (1) how long- and short-term rates relate to each other
and (2) what causes shifts in their relative levels.

As the figure shows, the yield curve changes in position and in slope over time.

 In March 1980, all rates were quite high because high inflation was expected. However, the rate
of inflation was expected to decline; so short-term rates were higher than long-term rates, and
the yield curve was thus downward-sloping.
 By February 2000, inflation had indeed declined; thus, all rates were lower, and the yield curve
had become humped—medium-term rates were higher than either short- or long-term rates.
 By January 2008, all rates had fallen below the 2000 levels; and because short-term rates had
dropped below long-term rates, the yield curve was upward-sloping.
“Normal” Yield Curve - an upward-sloping yield curve.

Inverted (“Abnormal”) Yield Curve - a downward-sloping yield curve.

Humped Yield Curve - a yield curve where interest rates on medium-term maturities are higher than
rates on both short-and long-term maturities.

Historically, long-term rates are generally above short-term rates because of the maturity risk premium;
so, all yield curves usually slope upward. For this reason, people often call an upward-sloping yield curve
a “normal” yield curve and a yield curve that slopes downward an inverted or “abnormal” curve. Thus,
in Figure 6-4, the yield curve for March 1980 was inverted, while the one for January 2008 was normal.
However, the February 2000 curve was humped, which means that interest rates on medium-term
maturities were higher than rates on both short- and long-term maturities.

We will explain in detail why an upward slope is the normal situation. Briefly, however, the reason is
that short-term securities have less interest rate risk than longer-term securities; hence, they have
smaller MRPs. So short-term rates are normally lower than long-term rates.

6-7 Macroeconomic Factors That Influence Interest Rate Levels 183

We described how key components such as expected inflation, default risk, maturity risk, and liquidity
concerns influence the level of interest rates over time and across different markets. On a day-to-day
basis, a variety of macroeconomic factors may influence one or more of these components; hence,
macroeconomic factors have an important effect on both the general level of interest rates and the
shape of the yield curve. The primary factors are

(1) Federal Reserve policy;

(2) the federal budget deficit or surplus;

(3) international factors, and

(4) the level of business activity.

 6-7a Federal Reserve Policy 183

One of the most important functions of the Federal Reserve System is to ensure that the amount of
money in the U.S. economy is consistent with noninflationary growth. The Fed controls the amount of
money in the economy by controlling the reserves in the banking system. If the Fed wants to stimulate
the economy, it increases the money supply.
The Fed buys and sells short-term securities, so the initial effect of a monetary easing would be to cause
short-term rates to decline. However, a larger money supply might lead to an increase in expected
future inflation, which would cause long-term rates to rise even as short-term rates fell.

 6-7b Federal Budget Deficits or Surpluses 184

So the larger the federal deficit, other things held constant, the higher the level of interest rates

If the federal government spends more than it takes in as taxes, it runs a deficit; and that deficit must be
covered by additional borrowing (selling more Treasury bonds) or by printing money. If the government
borrows, this increases the demand for funds and thus pushes up interest rates. If the government
prints money, investors recognize that with “more money chasing a given amount of goods,” the result
will be increased inflation, which will also increase interest rates.

 6-7c International Factors 184

Businesses and individuals in the United States buy from and sell to people and firms all around the
globe. If they buy more than they sell (that is, if there are more imports than exports), they are said to
be running a foreign trade deficit.

When trade deficits occur, they must be financed; and this generally means borrowing from nations with
export surpluses. Thus, if the United States imported $200 billion of goods but exported only $100
billion, it would run a trade deficit of $100 billion while other countries would have a $100 billion trade
surplus. The United States would probably borrow the $100 billion from the surplus nations.15 At any
rate, the larger the trade deficit, the higher the tendency to borrow.

Foreign Trade Deficit - The situation that exists when a country imports more than it exports

 6-7d Business Activity 185

1. A predictable correlation between the demand curve for funds and the supply curve is this: If the
demand curve for funds increases but the supply curve remains constant, then the total amount of
funds supplied and demanded increase and interest rates in general also increase.

True

2. Which of the following situations would be most likely to lead to an increase in interest rates in the
economy?

The level of inflation begins to decline.

Corporations step up their expansion plans and thus increase their demand for capital.

The economy moves from a boom to a recession.

Households start saving a larger percentage of their income.

3. If the U.S. Treasury were to issue $50 billion of short-term securities and sell them to the public, what
would be the most likely effect on short-term securities' prices and interest rates? Assume that other
factors are held constant.

Prices would decline and interest rates would rise

4. "Interest rate risk," also known as "price risk," is the risk that interest rates will increase, and that
increase will lead to a decline in the prices of outstanding bonds.

True

REAL RISK-FREE RATE

You read in The Wall Street Journal that 30-day T-bills are currently yielding 5.5%. Your brother-in-law, a
broker a Safe and Sound Securities, has given you the following estimates of current interest rate
premiums:

•Inflation premium = 3.25% •Liquidity premium = 0.6% •Maturity risk premium = 1.8% •Default risk
premium = 2.15% On the basis of these data, what is the real risk-free rate of return? Answer T-bill rate
= r* + IP 5.5% = r* + 3.25% r* = 2.25%.