Mean reversion is the empirical tendency of interest rates to return to a long-run equilibrium level over time. Periods of unusually high or low rates are followed by movements back toward the historical average, though the speed of reversion and the equilibrium level itself may shift over time.
Mean reversion in interest rates is supported by economic logic:
- High rates slow borrowing and economic activity, eventually leading to easing
- Low rates stimulate activity and inflation, eventually leading to tightening
- The central bank's mandate creates an anchor: the Fed targets inflation and employment, implicitly constraining how far rates can deviate from equilibrium
Mean reversion is a core assumption in most term structure models:
- Vasicek model: rates follow a mean-reverting process with normally distributed shocks
- Cox-Ingersoll-Ross (CIR) model: similar but with volatility proportional to the rate level, preventing negative rates
- ACM model: uses mean-reverting factors to generate yield curve dynamics
The speed of mean reversion matters:
- Fast mean reversion → short-term rate fluctuations are temporary, long-term yields are stable, the curve is flat
- Slow mean reversion → rate changes are persistent, long-term yields are volatile, the curve can sustain steep or inverted shapes
The z-score shown on the morning dashboard reflects mean reversion logic: yields far from their historical mean (high absolute z-scores) are statistically likely to revert, though the timing is uncertain. The Salomon Brothers yield curve primer (Part 7) provides the mathematical framework for mean-reverting rate models.