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expected nominal yield

A) Suppose that several months of data showed the CPI increasing at a 1% annualized rate down from previous 4% rate and this caused expectations of annual inflation to also decrease from 4% to 1%. Assume, at the same time that fears of recession and default on corporate and asset backed bonds reduced the expected real rate of return required to equate investor demand to the existing supply of 1 year Treasury notes to 0.5 % from 2%. What would you expect to happen to the nominal yields on 1-year T-notes during the period over which these changes in inflation expectations and required real yields occurred? (Give a numerical answer if possible) Explain your reasoning.

B)Draw a supply/demand diagram of the US Treasury bond market to illustrate the effects on it of the developments cited in part A. Label the diagram clearly.

Solution Preview

A)
Prior expectation of inflation was 4%.
New expected inflation rate is 1%.
With fear of default on commercial asset backed bonds people start demanding more treasury notes. The expected real returns fall from 2% to 0.5%.

First, relate the nominal yield to the real yield.

Nominal = Real + Inflation

In ...

Solution Summary

Identify expected nominal yield.

$2.19