Two factors along the yield curve

We estimate two-factor equilibrium models on different parts of the yield curve. In this exploration of the term structure of interest rates, we use two-factor affine yield models as our diagnostic tool. The exercise provides insights on how to reconcile the time-series dynamics of interest rates with the cross-sectional shapes of the term structure and on how movements in the yield curve are related to macroeconomic fundamentals. The evidence favors models in which one factor reverts over time to a time-varying mean. One such model seems adequate to explain three-month to two-year bond yields and another such model to explain two-year to ten-year yields. The models differ because mean reversion is much faster for yields near the short end of the curve than for yields near the long end. Near the short end, the implied factors capture mean reversion in inflation and the Federal Reserve's federal funds target rate. Near the long end, the factors also track the federal funds target but not inflation.