The nonlinear dynamics of interest rates

This note evaluates the nonlinear dynamics of interest rates using a three-regime threshold random-walk model and daily, annualized 3-month, 6-month, 1-year, 5-year, 10-year and 30-year US Treasury rates from 4 January 1971 to 31 December 2002. The idea behind this model is that loans occur in all three regimes, but there is an added incentive to lend (borrow) money after interest rates rise (fall) by a large amount. This model finds statistically-significant evidence that interest rates are consistent with a regime-reverting process where on average, interest rates in the two outer regimes revert to the middle regime. This regime-reverting process implies that interest rates have a stabilizing force consistent with a reversal effect.