Evolution of The Yield Curve and the Business Cycle: An Econometric Model

We propose a framework to model the evolution of the entire yield curve over time, maintaining consistency with the cross sectional fit across maturities. Using a parsimonious representation of the business cycle, namely the loop representation, as the key driver of the yield curve, the model combines the cross sectional properties like the curve shape with its dynamic evolution, depending on the business cycle. In doing so the model accounts for the spatio-temporal correlation structure of the yields.The model establishes a mapping between the stylised phases of the business cycle and stylised yield curve shapes in those phases. We provide empirical evidence using data from the U.S.A.