The Treasury Yield Curve as a Cointegrated System

This paper examines the temporal relationship between interest rates on Treasury securities ranging in maturity from three months to 30 years. We find strong empirical support that the seven Treasury rates selected are cointegrated, a conclusion that is insensitive to the normalization chosen. In particular, the hypothesis of noncointegration is rejected decisively regardless of the rate selected as the dependent variable in the cointegrating equation. To determine whether this information can be used to improve forecasts of Treasury rates, the seven rates are forecasted with a corresponding errorcorrection model that is shown to outperform an augmented VAR model that ignores the cointegration of the rates. The results are consistent with the belief that arbitrage limits the extent to which rates on different maturities of a given security diverge. In addition, the results confirm the appropriateness of imposing a common stochastic process for interest rates in equilibrium models of the term structure.