FNCE 4102 Week 2 Yield Curve Rate Structure Note Example

The Treasury Yield Curve on December 31, 2021: Upward Sloping and Steep Through Five Years, Read Through Expectations, a Term Premium and Segmented Demand, With What Each Theory Explains and Misses

Student Name

Walden University

FNCE 4102: Financial Institutions and Markets

Instructor Name

Month Day, Year

The Treasury Yield Curve on December 31, 2021: Upward Sloping and Steep Through Five Years, Read Through Expectations, a Term Premium and Segmented Demand, With What Each Theory Explains and Misses

The Curve

On the last trading day of 2021, according to the Treasury's daily par yield curve (U.S. Department of the Treasury, n.d.), yields rose from almost zero at three months to 1.90 percent at thirty years. The curve was upward sloping and steepest at the short end: yields rose about 0.68 percentage points between three months and two years, another 0.53 points between two and five years and only 0.64 points across the remaining twenty-five years. Note that the 20-year yield that day, 1.94 percent, was slightly above the 30-year, a small kink at the long end.

Figure 1

U.S. Treasury Par Yield Curve, December 31, 2021

Source: U.S. Department of the Treasury daily par yield curve rates, December 31, 2021. Points are plotted at equal spacing, not to scale by maturity.

Expectations

The expectations theory holds that a long-term yield is an average of the short-term rates investors expect over the bond's life (Mishkin & Eakins, 2018). In December 2021, the Federal Reserve was holding its policy rate near zero but had signaled it would begin raising rates in 2022 to fight inflation running above 6 percent. If investors expected short rates to climb over the next few years and then level off, the expectations theory predicts exactly this shape: a sharp rise through two to five years and a flatter curve beyond. The theory explains the steep front end well, and it matches what the Federal Reserve was telling markets at the time.

What it misses is the persistence of upward slope. Over decades, yield curves have sloped upward far more often than short rates have actually risen, which the pure expectations theory cannot explain.

A Term Premium

The liquidity premium theory, traced to Hicks (1939), adds a premium that investors demand for holding longer bonds, whose prices swing more when rates change. Even if investors expected short rates to stay flat, long yields would sit above short yields by that premium. The premium helps explain why the 30-year yield sat above the 10-year. Estimates of the term premium in late 2021, however, were close to zero or negative, so most of the slope that day came from expected rate increases rather than a large premium.

Segmented Demand

Segmented markets theory argues that different investors prefer different maturities and do not easily switch (Culbertson, 1957). Pension funds and life insurers need long bonds to match their long liabilities and buy 30-year Treasuries almost regardless of small yield differences. That steady demand helps explain the slight inversion between 20 and 30 years: strong demand for the benchmark 30-year bond held its yield a little below the less-traded 20-year. Modigliani and Sutch (1966) softened the theory into a preferred-habitat view in which investors can be drawn out of their preferred maturity by a high enough premium.

Why the Shape Mattered to Institutions

The slope of the curve is not only a matter for economists; it shapes how financial institutions earn money. A commercial bank funds itself largely with deposits that behave like short-term borrowing and lends for years through mortgages and business loans. A steep curve widens the gap between what it pays and what it earns. In December 2021, banks were paying almost nothing on deposits while new five-year loans priced off a 1.26 percent Treasury yield plus a credit spread, which supported their margins despite very low rates overall. Life insurers face the opposite problem: their promises run for decades, so they care most about long yields, and 1.90 percent at thirty years made it hard to earn the returns their policies assumed. Money market funds, which hold only short paper, earned almost nothing at all and in many cases waived fees to avoid paying investors a negative return. The same curve, in other words, helped one kind of institution, squeezed a second and nearly stalled a third, which is why the course returns to it when it studies each institution in turn.

What the Curve Said

Read together, the theories suggest the December 2021 curve mainly reflected expected rate increases over the next few years, with a small term premium and some long-end distortion from institutional demand. In the event, short rates rose far faster than the curve implied: the Federal Reserve raised its target range by more than four percentage points during 2022. The curve correctly signaled the direction but badly underestimated the speed, a reminder that it records expectations, not forecasts that are guaranteed to hold.

References

Culbertson, J. M. (1957). The term structure of interest rates. The Quarterly Journal of Economics, 71(4), 485-517. https://doi.org/10.2307/1885708

Hicks, J. R. (1939). Value and capital: An inquiry into some fundamental principles of economic theory. Clarendon Press.

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed.). Pearson.

Modigliani, F., & Sutch, R. (1966). Innovations in interest rate policy. The American Economic Review, 56(1/2), 178-197.

U.S. Department of the Treasury. (n.d.). Daily Treasury par yield curve rates. https://home.treasury.gov/resource-center/data-chart-center/interest-rates