This problem requires an understanding of how economic conditions affect interest rates and bond yields (Chapters 1, 2, and 3).
Your task is to use information about existing economic conditions to forecast U.S. and Canadian interest rates. The following information is available to you.
1. Over the past six months, U.S. interest rates have declined and Canadian interest rates have increased.
2. The U.S. economy has weakened over the past year while the Canadian economy has improved.
3. The U.S. saving rate (proportion of income saved) is expected to decrease slightly over the next year; the Canadian saving rate will remain stable.
4. The U.S. and Canadian central banks are not expected to implement any policy changes that would have a significant impact on interest rates.
5. You expect the U.S. economy to strengthen considerably over the next year but still be weaker than it was two years ago. You expect the Canadian economy to remain stable.
6. You expect the U.S. annual budget deficit to increase slightly from last year but be significantly less than the average annual budget deficit over the past five years. You expect the Canadian budget deficit to be about the same as last year.
7. You expect the U.S. inflation rate to rise slightly but still remain below the relatively high levels of two years ago; you expect the Canadian inflation rate to decline.
8. Based on some events last week, most economists and investors around the world (including yourself) expect the U.S. dollar to weaken against the Canadian dollar and against other foreign currencies over the next year. This expectation was already accounted for in your forecasts of inflation and economic growth.
9. The yield curve in the United States currently exhibits a consistent downward slope.
The yield curve in Canada currently exhibits an upward slope. You believe that the liquidity premium on securities is quite small.
Madura, Jeff (2014-01-01). Financial Markets and Institutions (Page 77). Cengage Learning. Kindle Edition.
Questions
1. Using the information available to you, forecast the direction of U.S. interest rates.
2. Using the information available to you, forecast the direction of Canadian interest rates.
3. Assume that the perceived risk of corporations in the United States is expected to increase. Explain how the yield of newly issued U.S. corporate bonds will change to a different degree than will the yield of newly issued U.S. Treasury bonds.