Problems with Traditional Theories

To illustrate some problems with traditional theories, we could examine the behavior of the term structure in the last two decades. What we would find is that the term structure is almost always upward sloping. But contrary to the expectations hypothesis, interest rates have not always risen. Furthermore, as we saw with STRIPS term structure, it is often the case that the term structure turns down at very long maturities. According to the expectations hypothesis, market participants apparently expect rates to rise for 20 or so years and then decline. This seems to be stretching things a bit.
In terms of maturity preference, the world’s biggest borrower, the U.S. government, borrows much more heavily short term than long term. Furthermore, many of the biggest buyers of fixed- income securities, such as pension funds, have a strong preference for long maturities. It is hard to square these facts with the behavior assumptions underlying the maturity preference theory.
Finally, in terms of market segmentation, the U.S. government borrows at all maturities. Many institutional investors, such as mutual funds, are more than willing to move maturities to obtain more favorable rates. Finally, there are bond trading operations that do nothing other than buy and sell various maturity issues to exploit even very small perceived premiums. In short, in the modern fixed- income market, market segmentation does not seem to be a powerful force.