The Expectations Hypothesis Holds. At Times

Advisor: Carlos Viana de Carvalho

Co-advisor: Ruy Monteiro Ribeiro

The yield curve literature typically assumes long-term interest rates are given by expected future short-term rates and/or risk premia. We show that the relative importance of the expectational component vis-à-vis the risk premium component can be time-varying and state-dependent. Further, the likelihood of an "Expectations Hypothesis (EH) State" has a clear relation to the business cycle. Moreover, our results indicate that incorporating the probability of these EH states boosts the predictive power of the benchmark yield curve measure, the term spread, both for future excess bond returns and economic activity