Hi, 1) Page 9 chapter 20 mentions: Key information However, investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potentially inflationary consequences over the longer term. So the yield on long bonds might decline by a smaller amount, or even rise. 2) Also, solution 20.5 has one of the points below as a solution: Higher short-term interest rates can reduce inflationary expectations and so tend to reduce long-term yields. These two seem related - vice versa situation. I did not understand how high short term interest rates can reduce inflationary expectations.
It all depends on whether the market believes that the government is serious about getting inflation under control by raising short-term interest rates. The raising of short-term rates sends a message that says that the government is prepared to accept reduced economic growth in order to control inflation. If this message is believed then investors will require less compensation for holding longer-dated bonds which are more exposed to the effect of inflation.
Understood what you're saying. Just to reiterate what I understood here: "However, investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potentially inflationary consequences over the longer term. So the yield on long bonds might decline by a smaller amount, or even rise." If I have to break this statement down to interpret it, Cut in interest rates => long term inflation will be high => since coupons and capital repayment is fixed, demand for this bond will fall => price of this bond will fall => yield will go up, given the same coupons but lower price due to expectation of higher inflation. But this does not match with the core reading statement above! Also, what is the basic assumption when we talk about effect on bonds yields and interest rates about the bond being already bought or not and whether it will be held to maturity or not?
Your breakdown is fine, and that's what the Core Reading means when it says "or even rise". The fact that the yield on long bonds might decline, coupled with the fact that they might increase, means that the outcome is uncertain. The paragraph of ActEd notes at the top of page 9 might help with this. Let me know if not! If bonds are held to maturity, then no one cares what happens to the price (or the yield). The yield curve only becomes an interesting question if you're looking to buy or sell bonds, so the theories must assume that there's an active bond market.
