What Does Yield Curve Smoothness Mean?

The degree of smoothness of interest rates alongside the maturity spectrum can provide indications regarding the degree of quot;arbitrage trading activityquot; in interest rate markets, which in turn may be related, to some extent, to market expectations, risk aversion and market liquidity. We present two main applications of smoothness indicators. First, using tick data for the money market of the euro we show that fluctuations in smoothness in a very liquid market reflect some changes in the pattern of risk aversion amongst market participants. Second, we compare developments in smoothness in government bond markets across five countries (Germany, Spain, France, Japan and the United States). Amongst various results, we find that the degree of smoothness declines in periods of heightened financial market volatility and liquidity dry-ups. In particular, smoothness was low in the United States, Japan and France during the episode of financial market turbulence of the autumn of 1998