Fear of Default and Bond Yields
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Suppose investors believe the US will temporarily default on its debt payments in three months due to failing to agree to lifting the debt ceiling. What effect has this on the price and yield of US treasury bills and bonds with a maturity of 1 month, 3 month and 3 years and how does it affect the shape of the US yield curve.
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Solution Summary
Yield structures are affected more or less the same when there is a belief of an imminent default. Investors know that the very short term will be much less affected than the medium term, when the effects of the default will be at full swing. The very long term will go up, but not nearly as much. It's based on the ability to reasonably predict the time periods. The further in the future, the more difficult.
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Suppose investors believe the US will temporarily default on its debt payments in three months due to failing to agree to lifting the debt ceiling. What effect has this on the price and yield of US treasury bills and bonds with a maturity of 1 month, 3 month and 3 years and how does it affect the shape of the US yield curve.
This sort of severe negative expectation almost always leads to a spike in yields for the short term, but, as this is 3 months away, not the very short term. So the yield curve would be inverted as the "middle" between the 1 month and 3 years is the most effected. The general model of this fear is that output and consumption fall, so the focus will be on the shorter term. Confidence has been undermined, but whether there is a belief of permanent instability or just a short term crisis (like the oil shock of the 1970s, something outside the system) is the key variable.
Last year, investors in Argentina believed that country would soon default. The short term impact was a rise in inflation, more expensive imports, and increased ...
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