An economic report indicates that market expectations of future inflation are driving up long-term U.S. Treasury yields, while Federal Reserve policy actions keep short-term interest rates relatively stable. This movement causes the U.S. Treasury yield curve to transition from a flat shape to a steep upward slope. Based on these interest rate dynamics, which of the following statements correctly describes the effect on existing bond prices and the underlying economic outlook?
- Existing long-term bonds will experience a larger price decline than short-term bonds, and the steepening curve generally reflects expectations of economic expansion.Answer
- BExisting long-term bond prices will increase because rising market yields boost the overall market value of outstanding fixed-income securities.
- CThe steepening yield curve acts as a primary indicator of an impending economic recession, causing short-term bonds to lose value much faster than long-term bonds.
- DThe Federal Reserve directly adjusts corporate tax rates and government spending to force long-term yields higher while maintaining reserve requirements.
Answer
Existing long-term bonds will experience a larger price decline than short-term bonds, and the steepening curve generally reflects expectations of economic expansion.
The correct answer accurately applies two fundamental principles of fixed-income and yield curve analysis. First, bond prices share an inverse relationship with prevailing interest rates; as long-term yields increase, existing long-term bond prices decrease. Because long-term bonds have longer duration, their market prices are significantly more sensitive to yield changes than short-term bonds. Second, a steeply upward-sloping yield curve generally reflects market expectations of economic growth, rising demand for credit, and higher future inflation.
Step-by-Step Solution
Key Concept
Yield Curve Dynamics, Bond Duration Risk, and Economic Indicators