Three main forces determine the term structure of forward rates: the market’s rate expectations; required bond risk premia; and the convexity bias. Many market observers believe that the first force is the dominant one. This article focuses on the impact of the market’s rate expectations on the yield curve shape but emphasizes the consequences of ignoring the two other forces.
The impact of rate expectations on today’s yield curve shape is best isolated by assuming that the pure expectations hypothesis holds. According to this hypothesis, all government bonds have the same near-term expected return (that is, all bond risk premia are zero). If the near-term expected returns are equal across maturities, initial yield differences must offset any expected capital gains or losses that are caused by the market’s rate expectations.
For example, if the market expects rates to rise and long-term bonds to suffer capital losses, long-term bonds must have an initial yield advantage of the one-period bond (to offset the expected capital losses). Therefore, expectations of rising rates tend to make today’s yield curve upward-sloping. Conversely, expectations of declining future rates tend to make today’s yield curve inverted. In a similar way, the market’s expectations of future curve flattening or steepening influence the curvature of today’s yield curve.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.