April 2017 Paper 1 Q5(ii)(b)

[rlsrachaellouisesmith]

Hi

I wonder if you can confirm my understanding.
Do long term bond yields depend on future expectations of short term rates according to expectations theory?
That is if short term rates have been increased but expectation is that rates will return to their lower levels in the medium to long term then a change in short term rates may have limited impact on long term yields?
In the model solution only expectations on inflation are mentioned when discussing impacts on long term bond yields.

Thank you

 

[Helen Evans]

Hello

Thank you for your post. Long-term bond yields will be affected by the expectations of interest rates over their term, ie by the current interest rates but also the interest rates later in their term. The outlook can be uncertain but the market will take a view of the future direction.

As you suggest it might be that interest rates are currently high but the market predicts that the central bank will cut rates in future to try and stimulate the economy (and the cut in interest rates is likely to cause inflation) ... the yield on longer term bonds will then reflect both the high interest rates now but also these lower expected interest rates in the future.

I hope this helps and your studies are going well.

Helen

 

[rlsrachaellouisesmith]

Thank you Helen, that confirms my thoughts, thank you.