Money, Banking, and International Financecharacteristics. First, the yield curve usually slopes upward because the long-term securities
have higher interest rates than short-term securities. Consequently, T-bonds would usually have
a greater interest rate than T-bills. Second, interest rates move together, so the yield curve
normally shifts upward or downward as the interest rates change.
Economists use three theories to explain why the yield curve has these two characteristics.
Segmented markets theory is supply and demand in each bond market determine the
interest rate. For example, U.S. government securities are classified into specific and separate
markets based on maturities. One group of investors only invests in T-bonds, while another
group invests in T-bills. Consequently, the yield curve usually slopes upward because people
prefer to hold short-term bonds rather than long-term bonds. Unfortunately, this theory cannot
explain why interest rates move together in different markets, shifting the yield curve. If the
markets of different maturities are separated and independent, a change in one bond market
would not affect another market.
Expectations theory states investors view all securities with the same liquidity, risk,
information costs, and taxes as perfect substitutes. Consequently, the interest rate on a long-term
bond must equal the average of short-term interest rates that people expect to occur over the life
of the security. For example, the current market interest rate on a one-year bond equals 9%. You
expect the interest rate to rise to 11% next year, so when you buy another one-year bond for the
following year, the average interest rate you expect to earn is 11%. If you decide to hold a two-
year bond, the interest rate must be 10% because the interest rate will be 9% for the first year,
and you believe interest rates will increase to 11% for the second year. After we average the two
years, your return would equal 10%. If investors expect that short-term interest rates will rise,
then the yield curve has a positive slope. If investors expect that short-term interest rates will
drop, subsequently, the yield curve has a negative slope. If investors expect short-term interest
rates will not change, then the yield curve becomes flat. Although expectations theory explains
why short-term and long-term interest rates move together, the theory cannot explain why the
yield curve usually has a positive slope. This implies investors would think short-term interest
rates will increase most of the time, but the short-term interest rate could fall or rise.
Preferred habitat theory is the most widely accepted theory and combines the expectations
theory and segment markets theory together. Investors prefer to hold short-term bonds with a
low, expected return because investors prefer that type or habitat. Money market securities
fluctuate less than capital market securities as interest rates change. However, the investors will
invest in long-term bonds if they earn a term premium, a higher interest rate. Consequently, the
yield curve slopes upward because the investors add the term premium to long maturity bonds.
Preferred habitat theory, furthermore, explains why the long and short-term interest rates
move together. Interest rate on a long-term bond equals the average of the short-term interest
rates expected to occur over the life of the long-term bond. If investors expect the short-term
interest rates will increase, then the yield curve has a positive slope. If investors expect that
short-term interest rates will decrease, subsequently, the yield curve will have a negative slope.
However, investors add a term premium, so the yield curve has a positive slope because the term
premium is high enough to cancel the effect of changing interest rates.