Expectation Theory and Liquidity Theory

Berg observes that the current Treasury bond yield curve is upward sloping. Based on this observation, Berg forecasts that short-term interest rates will increase.

Is Berg’s short-term interest rate forecast consistent with the pure expectations theory and the liquidity premium theory?

A)Consistent with the pure expectations theory only. B)Consistent with both theories. C)Consistent with the liquidity premium theory only.

Schweser states A is the answer

"An upward sloping yield curve predicts an increase in short-term rates according to the pure expectations theory but not necessarily the liquidity premium theory.

The liquidity theory says that forward rates are a biased estimate of the market’s expectation of future rates because they include a liquidity premium. Therefore, a positively sloping yield curve may indicate either (1) that the market expects future interest rates to rise or (2) that rates are expected to remain constant (or even fall), but the addition of the liquidity premium results in a positive slope."

But since the criteria of expected short-term rates to increase is being met shouldn’t the answer be B?

NOT NECESSARILY. That is how the option A is the answer.

why not? doesnt an upward sloping curve means you are getting compensated for liquidity?

An upward sloping yield curve under the liquidity premium theory does not mean that rates are increasing. It just means that the liquidity premium increases with longer maturities. So you may have a flat yield curve ( flat rates)that is upward sloping solely because of the liquidity premium.

In other words, short term rates may not increase but the liquidity premium might.

The point is that under liquidity (preference) theory, that criterion isn’t necessarily being met; there’s no reason to conclude that short-term interest rates will increase merely because the yield curve slopes upward.

I saw another thread asking the same question and I’m still a bit puzzled about this concept.
Does it mean that liquidity premium has nothing to do with the yield curve of the interest rate term and that it solely focuses on the liquidity premium that investors demand?

can we say that liquidity premium can be 0 and short term rates are still increasing which ties back to the expectation theory?


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thanks Bill! You are the best

My pleasure.