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There are three
basic theories that attempt to explain changing yield curves. The first is
called the expectation theory. This theory states that long-term
interest rates today will become the short-term rates of the future.
Upward curves mean investors expect interest rates to rise and are bidding down
the prices of long-term bonds, increasing their yields. Downward curves
mean investors expect interest rates will decrease in the future, and are
bidding up the prices of long-term bonds, decreasing their yields.
The liquidity preference theory states that investors
would rather not tie up their capital in long-term investments, and will only do
so if they are rewarded for it. This reward takes the form of receiving
higher interest from longer-term bonds than from shorter-term bonds. This theory
accounts only for upward-sloping yield curves.
The combined yield curve theory says that both the
expectation and liquidity preference theories are correct, leading to different
types of yield curves. When interest rates are expected to rise, both
theories push the yield curve upward. When they are expected to fall,
expectation forces oppose liquidity preference forces, causing the yield curve
to slope down. |
