The Forecasting Power of International Yield Curve Linkages

We investigate whether international linkages in interest rates help forecast domestic yield curves out-of-sample. We propose a novel international setting to forecast yield curves, based on dynamic factor models, the EM algorithm and the Kalman filter. We apply this methodology on three major countries, the US, Germany and the UK. We allow information from foreign yield curves to enrich the information set of the domestic yield curve. Each domestic yield curve is summarised by three factors (level, slope and curvature). Our results show that the international model outperforms the purely domestic model in forecasting the yield-curve of countries with lagging dependency patters. Intuitively, our results reveal a dynamic dependency of the German yield curve on the US and the UK and, to a lesser extent, of the UK yield curve to the US and Germany. The US yield curve appears detached from transatlantic developments