The shape of the U.S. Treasury yield curve appears to reflect two expected Federal Reserve reductions in the federal funds rate. The current short-term interest rate is 5%. The first reduction of approximately 50 basis points (bp) is expected 6 months from now and the second reduction of approximately 50 bp is expected 1 year from now. The current U.S. Treasury term premiums are 10 bp per year for each of the next 3 years (out through the 3-year benchmark).
However, the market also believes that the Federal Reserve reductions will be reversed in a single 100-bp increase in the federal funds rate 2½ years from now. You expect liquidity premiums to remain 10 bp per year for each of the next 3 years (out through the 3-year benchmark).
Describe or draw the shape of the Treasury yield curve out through the 3-year benchmark.
Which term structure theory supports the shape of the U.S. Treasury yield curve you’ve described?
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