The shape of the U.S. Treasury yield curve appears to reflect two expected Federal Reserve reductions in the federal funds rate. The current short-term interest rate is 5%. The first reduction of approximately 50 basis points (bp) is expected six months from now and the second reduction of approximately 50 bp is expected one year from now. The current U.S. Treasury term premiums are 10 bp per year for each of the next three years (out through the 3-year benchmark).

However, the market also believes that the Federal Reserve reductions will be reversed in a single 100-bp increase in the federal funds rate 2 1 ⁄ 2 years from now. You expect liquidity premiums to remain 10 bp per year for each of the next three years (out through the 3-year benchmark).

Describe or draw the shape of the Treasury yield curve out through the 3-year benchmark.

Which term structure theory supports the shape of the U.S. Treasury yield curve you’ve described?