The pure expectations hypothesis (PEH) states that a long-term bond yield equals the average of current and expected future short-term rates over the bond's life. Under this theory, the yield curve's shape reflects only the market's forecast of the path of short-term rates — no risk premium exists.
If the PEH held perfectly:
In reality, the PEH fails empirically. Research by Fama and Bliss (1987), Campbell and Shiller (1991), and others shows that long-term yields systematically overpredict future short rates. The Salomon Brothers yield curve primer series documents that forward rates are biased predictors of future rates, consistently overstating the magnitude of future rate increases.
The failure of the PEH implies the existence of a term premium — extra compensation investors demand for bearing duration risk. The yield curve's shape therefore reflects both rate expectations and a time-varying risk premium, and disentangling the two requires a model (such as the ACM model).
This distinction matters practically. A steep yield curve could mean either that rates are expected to rise (expectations component) or that the term premium is high (risk component). The policy implications are very different.