How does liquidity shape the yield curve?

TL;DR

This paper introduces a microstructural model linking liquidity, order flows, and the forward rate curve, explaining price fluctuations and correlations with fewer parameters than existing models.

Contribution

It develops a microstructural framework that connects order flow surprises to forward rate dynamics, incorporating impact effects with enhanced explanatory power.

Findings

Model matches empirical liquidity-dependent correlations

Accounts for non-martingale price behavior at short timescales

Uses fewer parameters than traditional cross-impact models

Abstract

The phenomenology of the forward rate curve (FRC) can be accurately understood by the fluctuations of a stiff elastic string (Le Coz and Bouchaud, 2024). By relating the exogenous shocks driving such fluctuations to the surprises in the order flows, we elevate the model from purely describing price variations to a microstructural model that incorporates the joint dynamics of prices and order flows, accounting for both impact and cross-impact effects. Remarkably, this framework allows for at least the same explanatory power as existing cross-impact models, while using significantly fewer parameters. In addition, our model generates liquidity-dependent correlations between the forward rate of one tenor and the order flow of another, consistent with recent empirical findings. We show that the model also account for the non-martingale behavior of prices at short timescales.