What drives a yield curve shape?

Question

I understand there are many factors that affect yield curve shape, let me help understand one.

One is that 30y rate is an average 2y rate for the next 30y, with some additional premium. That premium is the fact that you are not able to collect 2y rate as your u go and rather locking the money for the entire 30y. What drives that premium/or discount? And how does it relate to average 2y rate going forward.

I hear on the news that 10y or 30y rate is the average short term rate going forward but I think it is not accurate because you are not able to realize this short rate changes when you hold long term bond. Please help me understand what drives the shape.

Answer 1

It's generally accepted that there are three factors at play and together they shape the yield curve. At times the change in some factors may be more prominent than others, but they always coexist.

1. Expectation

The most intuitive explanation. In short shape of yield curve reflects where we think rates are going to be. Nothing else.

2. Liquidity preference

Basically what you said. All else equal one would rather hold short bonds for easy access to cash. So we demand more premium as maturity lengthens. Hence this calls for upward sloping yield.

3. Market segmentation

Some market participants are limited in the type of treasury they can trade. So the rate at each tenor is determined by the supply and demand of the players in that segment. E.g. pension typically hold long treasuries and their trades affect the long end of the curve a lot more than the short end. There is also a derivation of this thoery that suggests if compensated well enough people might drift away from their preferred segment.

Answer 2

One is that 30y rate is an average 2y rate for the next 30y,

No, the 30Y rate and the 2Y rate are the market's expectation of overnight interest rates (that the government largely controls) over that time period. You can think of the 20y as an average 2Y rate over time, but the 2Y rate itself is driven be market expectations of the overnight rate in the end.

Those overnight rates are driven by lots of things, as is the market's expectation for future rates. Things like economic growth, unemployment, savings, taxes, etc. drive interest rates (and largely inflation expectations). Those are what drives the 2Y and 30Y rates.

I hear on the news that 10y or 30y rate is the average short term rate going forward but I think it is not accurate because you are not able to realize this short rate changes when you hold long term bond.

It's the market's expectation of the short term rate going forward. Yes if you hold a 30Y bond you are not directly affected by changes in the 2Y rate (your coupons are fixed), but what if you had an instrument that did give you the current 2Y rate every 2 years for the next 30 years (they do exist and are called Interest Rate Swaps)? At what point would you be indifferent about buying that instrument and a fixed-rate 30Y bond? The equivalent rate of a bond would be the expected average 2Y rate over that 30 years.