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 an d Watson (1988, Journal of the American Statistical Association 83, 10 97-1107), Park (1990, Working paper, Dept. of Economics, Cornell Unive rsity) and Gonzalo and Granger (1991, Working paper, University of Cal ifornia-San Diego). Three- and six-month interest rates for four sub-p eriods between 1910 and 1989 are decomposed into permanent and transit ory components. The results of the decomposition technique indicate th at the failure of the spread between three- and six-month US Treasury bill rates to predict future short-rates during the post-1979 period r esults 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 predictive power during the 1979-1989 period when the permanent component is removed from the sho rt-rate.