Regime Switching in the Yield Curve

The paper investigates the effect of interest-rate variance on the shape of the <p> yield curve using a bivariate 2-state Markov switching model for the short-rate changes <p> and the yield curve slope. The two states are characterized by the variance of the shortrate <p> changes: Low and high variance. In the high variance regime the yield curve becomes <p> steeper with the interest-rate variance, in the low variance regime the slope is independent <p> hereof. A non-switching specification amounts to averaging across the two states. The <p> economy is in the high variance state during unusual economic periods.