The expectations theory of interest rates: Cointegration and factor decomposition

This paper empirically re-examines the expectations theory of the term structure by using the decomposition procedures developed by Stock and Watson, Park and Gonzalo and Granger. Three- and six-month interest rates for four sub-periods between 1910 and 1989 are decomposed into permanent and transitory components. The results of the decomposition technique indicate that the failure of the spread between three- and six-month U.S. Treasury bill rates to predict future short-rates during the post-1979 period results from the fact that the variation in the permanent components of interest rates dominates relative to the variation of the transitory components. The spread is found to provide predicative power during the 1979-1989 period when the permanent component is removed from the short-rate.