We have heard the predictions regarding the large number of people that will be retiring over the next 25-50 years and the strain this is going to place on the federal budget. Assuming that federal borrowing will have to increase, what is the likely impact going to be on the risk and term structure (if any) of interest rates and why?

Question

What will be an ideal response?

Answer 1

Increased borrowing by the U.S. Treasury may certainly cause interest rates to increase, however the U.S. Treasury will still be the benchmark bond or the default-free bond. Other bonds will still have their yield calculated by taking the default-free rate (now perhaps higher) and adding the appropriate risk premium to this rate. As a result, greater borrowing by the U.S. Treasury would likely result in an increase in all yields. Regarding the term structure, this may depend on the selection of instruments used by the Treasury. For example, if the Treasury decides to finance the deficit by issuing only long-term (30 year) bonds, the price of these bonds will adjust to market forces. In order to attract buyers their price may fall and their yields increase causing the slope of the yield curve to increase. A similar argument could be offered if the Treasury decided to finance the deficit with mainly short-term instruments, in this case the subsequent market forces may cause the slope of the yield curve to decrease.