Impact of Economic Shock on Yield Curve

Very Hard Fixed Income Valuation Term Structure Of Interest Rates

During an economic downturn, central banks often adjust their monetary policies, which directly impacts the term structure of interest rates. Suppose a country experiences a significant economic shock, leading to a rapid decrease in short-term interest rates.

Simultaneously, long-term rates remain stable due to investor expectations of future economic recovery. As an analyst, you are tasked to interpret the implications of this scenario on the yield curve and bond pricing.

Which of the following statements about the expected shape of the yield curve in this context is most accurate?

The yield curve is likely to steepen, indicating that market participants expect future short-term rates to increase.

The yield curve is likely to flatten, reflecting market uncertainty about future economic conditions.

The yield curve could invert, suggesting that the market expects significantly lower long-term rates.

Hint

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