Question

Suppose short-term traders dominate the Treasury markets, that there are liquidity premiums, and that the markets expect the rate of inflation to fall over the next few years. On the basis of only this information, for today’s current yield curve which statement is the most accurate? 1. It is possible that short-term rates roughly equal long-term rates 2. The yield curve can be convex but not concave 3. Current long-term rates should definitely exceed current short-term rates 4. Current short-term rates should definitely exceed current long-term rates

Answer 1

If the market is expecting the rate of inflation to fall over the next few years it will mean that there will be lower demand due to lower inflation and there would be lower interest rates also and hence the long-term interest rates will be lower than the short term interest rates because there is an expectation of slowing economy in the long run.

All the other statements are false.

Correct answer will be option (4) current short term rates should definitely exceed current long term rates.