Expectations Hypothesis

The Expectations Hypothesis is an economic theory that suggests that long-term interest rates are determined by market expectations of future short-term interest rates. According to this hypothesis, the yield of a long-term bond is equivalent to the average of the expected future short-term rates over the bond’s life. If investors expect short-term rates to rise, long-term rates will also be higher, and vice versa. This theory helps explain the shape of the yield curve, which reflects market expectations of future interest rates. The Expectations Hypothesis is commonly used in fixed-income markets to analyze interest rate trends and forecast economic conditions.

Example

If the market expects short-term interest rates to increase over the next few years, the yield curve will slope upwards, reflecting higher long-term rates.