Explaining the Failures of the Term Spread Models of the Rational Expectations Hypothesis of the Term Structure

Contrary to the predictions of the rational expectations hypothesis of the term structure of interest rates, empirical evidence suggests that the term spread between long and short rates fails to forecast future movements of long term rates although its forecasts of future short term rates are in the correct direction. In this paper, we show that this puzzling behaviour of the term spread alone can be explained by a time-varying term premium which is correlated with the term spread. Once this is accounted for neither expression of the expectations hypothesis is against the predictions of the theory