In May 2012, the yields to maturity in the table below were recorded on Treasury

Question

In May 2012, the yields to maturity in the table below were recorded on Treasury discount bonds. If the expectations theory of the term structure holds, what do bond traders expect the interest rate on five-year discount bonds to be in May 2017, May 2022, May 2027, May 2032, and May 2037? Do bond traders expect the Federal Reserve to lose control of the inflation rate after 2017? Explain. In your explanation, suppose that after May 2017 the real interest rate will average two percent per annum.

Maturity Date
Yield to Maturity (%/year)
May 2017
0.88
May 2022
2.12
May 2027
2.89
May 2032
3.15
May 2037
3.30
May 2042
3.32

Explanation / Answer

Inflation is a bond's worst enemy Inflation erodes the purchasing power of a bond's future cash flows. Put simply, the higher the current rate of inflation and the higher the (expected) future rates of inflation, the higher the yields will rise across the yield curve, as investors will demand this higher yield to compensate for inflation risk.

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