Which theory does NOT apply in a downward sloping yield curve environment?

In a downward sloping yield curve environment, the Liquidity Preference Theory does not apply. This theory posits that investors require a premium for holding longer-term securities due to their relatively lower liquidity compared to short-term securities. Specifically, the theory suggests that a normal upward sloping yield curve reflects that investors demand this premium, resulting in higher yields for longer maturities.

In contrast, a downward sloping yield curve indicates that long-term interest rates are lower than short-term rates, which suggests that investors are not demanding additional yield for the additional risk and uncertainty associated with longer maturities. This situation could be interpreted as expectations of lower future interest rates or economic downturns, leading to investors favoring long-term investments for safety, rather than requiring a liquidity premium.

Expectations Theory, Market Segmentation Theory, and Cost Push Theory can still provide valid explanations in a downward sloping yield curve context. Expectations Theory explains the phenomenon as derived from expectations of future rates. Market Segmentation Theory highlights variations in different segments of the yield curve based on supply and demand, which can coexist with inverted curves. Meanwhile, Cost Push Theory, a concept rooted more in inflation and production costs, remains applicable irrespective of the yield curve shape. Therefore, Liquidity Preference Theory is the