Regime Switching in the Yield Curve

The paper investigates the effect of interest rate variance on the shape of the yield curve using a bivariate 2-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. The two variables are more strongly correlated in the high variance state. A non-switching specification amounts to averaging across the two states