Pure Expectations Hypothesis: This simplistic view is that investors price each individualTreasury entirely based on their expectations for future short-term interest rates. So if the yieldcurve is sloping upward (i.e. if 10 year treasuries yield more than 2 year treasuries), investorsmust believe that short-term interest rates will be higher in 2 years.Liquidity Preference Theory: This adjusts the "Pure Expectations Hypothesis" to take intoaccount the fact that investors generally don't like to be locked into a long-term contract. Mostinvestors will demand more yield to commit their money for a longer period of time. TheLiquidity Preference Theory explains why the yield curve is usually upward sloping.
Preferred Habitat Theory: This more subtle theory acknowledges that investors sometimeswant to hold debt for a specific amount of time. For example, a company may want to earninterest for 6 months until they must invest in a new factory. Alternatively, an insurancecompany may want to lock in a higher yield for 30 years to match the longer term liability of thelife insurance contracts they provide. The Preferred Habitat Theory can explain any shapedyield curve.
2) Basics in Action
The yield curve is generally upward sloping. If investors expect inflation and short-terminterest rates to remain steady, the yield curve will slope upward because investors valueliquidity (as explained by the Liquidity Preference Theory). If investors expect interest rates tofall, the yield curve may be flat or even downward sloping (inverted). Investors will accept alower return to lock in a yield for a longer period. For example, if short-term rates are currently4% and the market expects rates to fall to 1%, you might accept a 2% rate of return over 10years (as explained by the Pure Expectations Hypothesis). Throughout much of the19
century the US experienced deflation so the yield curve was often inverted.Beyond the shape of the yield curve, its absolute level gives us information about inflationexpectations and risk aversion.
If investors expect inflation of 5%, they’re likely to demand at
least 6% return to loan their money to the government. If investors view the world as volatile