How does liquidity shape the yield curve?

The phenomenology of the forward rate curve (FRC) can be accurately understood by the fluctuations of a stiff elastic string [Le Coz, V. and Bouchaud, J.-P., Revisiting elastic string models of forward interest rates. Quant. Finance, 2024, 1–18]. 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 accounts for the non-martingale behavior of prices at short time scales.