Question

Suppose the term structure of interest rates for U.S. government bonds is “flat” meaning that short...

Suppose the term structure of interest rates for U.S. government bonds is “flat” meaning that short (1-year maturity) and long (20-year maturity) term rates have the same expected actual return, say 3 percent. (This was the case a few years ago.) What would that mean about the market’s expectations for interest rate changes?

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Answer #1

The term structure of interest rates describes the differing YTMs for similar government bonds. Normally, a term structure is upward sloping implying that long-term rates are greater than short-term rates. A positive curve rate implies that investors require a higher rate of return to compensate the risk for holding the bond for a greater time period.Investors expect strong economic growth in the future, leading to higher inflation and thus, to higher interest rates.

If the term structure becomes flat, then long-term rates are becoming equal to short-term rates. It implies that investors are uncertain about the future economic growth and thus, do not require high interest rates compared to the short-term rates.

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