There are two main theories for interpreting the economic and social forces that shape the yield curve — the Expectations Theory and the Liquidity Preference Theory.
According to the Expectations Theory, investor expectations about the direction of future interest rates act as the force driving the yield curve. This is probably the most widely accepted yield curve theory and holds that long-term interest rates can be expressed by the average of future short-term rates.
For example, suppose today’s one-year interest rate is 3%, but the market expects next year’s one-year rate to increase to 4%. That would make today’s rate for two-year securities equal 3.5%, contributing to the formation of a positive yield curve. The Expectations Theory also accounts for inverted curves, as anticipated decreases in future short-term rates lower the averages that determine long-term yields. Since economists have traditionally considered rising and falling interest rates bellwethers of economic expansion and decline, proponents of the Expectations Theory consider the yield curve a valuable indicator of economic trends.
Liquidity Preference Theory
Other economists account for yield curve formation by way of the Liquidity Preference Theory, which focuses on investors’ natural inclination towards more liquid securities. By this theory, the risk premium demanded by investors who purchase long-term securities explains the yield curve’s positive tendencies. However, some economists and investment analysts believe that Liquidity Preference Theory falls short in explaining negative yield curves.
