Interest Rate Expectations and the Slope of the Money Market Yield Curve

Abstract

What determines the relationship between yield and maturity (the yield curve) in the money market? A resurgence of interest in this question in recent years has resulted in a substantial body of new research. The focus of much of the research has been on tests of the “expectations theory.” According to the theory, changes in the slope of the yield curve should depend on interest rate expectations: the more market participants expect rates to rise, the more positive should be the slope of the current yield curve. The expectations theory suggests that variation in the slope of the yield curve should be systematically related to the subsequent movement in interest rates. Much of the recent research has focused on whether this prediction of the theory is supported by the data. A surprising finding is that parts of the yield curve have been useful in forecasting interest rates while other parts have not.

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