Archive / Investment Adviser (Level 1) / Investing in Fixed Income Securities

nism-series-xa-pure-expectations-theory-yield-curve[ INVESTMENT ADVISER (LEVEL 1) ]

Under the 'Pure Expectations Theory' of the yield curve, what does an upward-sloping yield curve imply about future short-term interest rates?

[ A ]The market expects future short-term interest rates to rise in subsequent periods.[ CORRECT ]

[ B ]The market expects future short-term interest rates to decline to zero.

[ C ]The market expects inflation to drop to negative territory.

[ D ]The market assumes long-term bonds carry zero interest rate risk.

Takeaway

Under Pure Expectations Theory, an upward-sloping yield curve implies the market collectively expects future short-term interest rates to rise in subsequent periods.

Derivation

This theory assumes long-term rates are simply the geometric average of currently-expected future short-term rates, with no separate liquidity premium involved — so if the market expects short rates to be higher in the future than they are today, longer-maturity bonds (which lock in an average of those higher future rates) must yield more than short-maturity bonds today, producing an upward slope. Conversely, an inverted (downward-sloping) curve under this theory signals the market expects short-term rates to fall — often interpreted as an early warning of economic slowdown, since falling expected rates typically reflect anticipated central bank easing in response to weakening growth.

Why the others fail

B — The market expects future short-term interest rates to decline to zero.

An upward-sloping curve under Pure Expectations Theory implies the market expects future rates to rise.

C — The market expects inflation to drop to negative territory.

Pure Expectations Theory relates yield curve shape to expected future short-term interest rates, not directly to inflation expectations turning negative, which is a separate macroeconomic variable.

D — The market assumes long-term bonds carry zero interest rate risk.

This theory's core mechanism concerns rate expectations embedded in the yield curve shape; it does not assume long-term bonds carry zero interest rate risk — in fact all bonds carry rate risk under.