Since yield curves can take different shapes, they must change over time to produce these different shapes. But what drives these changes? How can we explain why a yield curve shifts and what factors might investors consider when predicting future changes? Unfortunately, there's no single answer to this. In fact, no single theory can fully explain the yield curve's, shape, or changes in its shape. Instead, several important theories try to capture different aspects of yield curve behavior. Let's go through some of the most significant ones, and let's start with the expectations theory. This theory suggests that the shape of the yield curve is driven by investors expectations about future interest rates. Long-term rates are essentially an average of what investors expect short-term rates to be over that longer period. In other words, the five year yield is the average of the expected one year yields over the next five years.

If investors expect short-term interest rates to rise, long-term bond yields will be higher than the current short-term rates. Resulting in an upward-sloping curve. If they expect short-term interest rates to fall, we might see an inverted yield curve as long-term yields drop below short-term ones. Next is the liquidity preference theory. According to this theory, investors demand a premium for holding longer term bonds because they carry more risk, such as uncertainty over inflation or interest rate movements. The term premium, the extra return investors get for holding longer dated bonds compensates investors for these additional risks. This demand for a higher return on longer term bonds would explain an upward sloping curve, even if investors don't expect short term rates to rise significantly in the future. Finally, the preferred habitat theory suggests that different investors have preferences for bonds of certain maturities. For instance, some investors might prefer short-term bonds because they offer greater liquidity. While others might favor long-term bonds for stability, to convince investors to move outside their preferred maturity range, say to buy longer term bonds, when they prefer shorter term ones, a higher yield is required, which could influence the overall shape of the yield curve.