Regime switching in the yield curve

The article investigates the effect of interest-rate variance on the shape of the yield curve with the use of a bivariate two-state Markov switching model for the short-rate changes and the yield curve slope. The two states are characterized by the variance of the short-rate changes: low and high variance. In the high-variance regime the yield curve becomes steeper with the interest-rate variance; in the low-variance regime the slope is independent hereof. A nonswitching specification amounts to averaging across the two states. The economy is in the high-variance state during unusual economic periods. (C) 2004 Wiley Periodicals, Inc.