Cointegration and Regime-Switching Risk Premia in the US Term Structure of Interest Rates

To date the cointegrating properties and the regime-switching behavior of the term structure are two separate strands of the literature. This paper integrates these lines of research and introduces regime shifts into a cointegrated VAR model. We argue that the short-run dynamics of the cointegrated model are likely to shift across regimes while the equilibrium relation implied by the expectations hypothesis of the term structure is robust to regime shifts. A Markov-switching VECM approach for U.S. data outperforms a linear VECM. We find significant shifts in risk premia and interest rate volatility. These regime shifts reflect changing inflation expectations and shifts in monetary policy, respectively