Expectations Theory

Way different from Expectorations Theory, which is taught and opined upon by baseball pitchers everywhere.

There are lots of fun expectations about which we could theorize. First dates. Christmas presents. Upcoming superhero movies.

Interest rates probably fall way down on your "fun things to theorize about expectations" list. But that's what the term "expectations theory" refers to. Not Christmas. Interest rates. Leave it to economists to get excited about the most boring things.

The basic idea of expectations theory goes like this: when you look at long-term interest rates, you can see people's expectation of what short-term rates will be in the future. Put another way, current long-term rates include a prediction of future short-term rates.

Under the theory, the market prices the various durations of bonds rationally. So the long-term rates include the sum total of expectations of all short-term rates along the way.

The example usually given involves a two-year rate and a one-year rate for the same type of bond. Buy two one-year bonds in succession, the rates will be lower than if you buy one two-year bond from the start. But take into account compounding interest, and you'll earn the same amount in both cases. Buying two one-year bonds successively leads to the same overall earnings as buying one two-year bond.