The pact, signed in the border town of Moyale, should help the local communities overcome the isolation that has been a barrier to development in the region, leaders say.
Kenyan President Uhuru Kenyatta and Ethiopian Prime Minister Hailemariam Desalegn hope it will bring peace and stability to their borders in the region, as well as bring about sustainable development in the northern Marsabit county of Kenya and Ethiopia’s southern Borana zone.
Around two-thirds of the population of Kenya's Marsabit County, more than 70,000 people, have fled, mostly to Borana, where many have relatives.
The main economic focus of the deal is on developing the area’s untapped energy and mineral resources and meat and livestock trade to create jobs for youth.
Trade relations between the two neighbouring countries leave room for improvement but this is nevertheless a milestone.
"This is certainly a significant development in trade between Kenya and Ethiopia which, although they’re neighbours, have as yet at any rate very limited amount of trade between them," Christopher Clapham, from the African Studies Centre at Cambridge University, told RFI.
"The latest figures I have are of the order of 13 to 14 million dollars a year from Kenya to Ethiopia and only about a third of that from Ethiopia to Kenya. So there’s a big gap to be filled there."
The move is seen as a first step towards allowing further economic growth in the region. Kenya already has some agreements with its neighbours but few with Ethiopia.
This deal, a five-year integrated programme signed in partnership with the United Nations and the Intergovernmental Authority on Development, is a follow-up on an initiative launched in October 2015. That deal was launched by the UN, the World Bank and the regional trade bloc Igad to boost economic growth, reduce poverty and promote business activities in the Horn of Africa through cross-border cooperation.
"So far this is only a bilateral deal but Kenya already has very close trade relations with its other east African partners within the east African community," Clapham points out. "And Ethiopia is looking very actively to build its own economic relations with its neighbours, most importantly with Sudan and, once as we hope the political situation is settled, South Sudan. So there’s a wider regional context to this."
There is also a significant political element to the deal. Kenya and Ethiopia have been allies in regional politics and it would allow them to work even closer together.
Clashes between herding communities over grazing land, water and cattle have become increasingly deadly due to an influx of guns and human traffickers, as well as political power struggles and fast-growing populations.
"It’s certainly is going to be difficult, with most of Ethiopia’s neighbours, with South Sudan in a state of civil war, and with Eritrea, which has blocked its relationship with Ethiopia for many years," Clapham says.
"That only leaves Djibouti which is the critical export link for Ethiopia and a further element in the Ethiopia-Kenya deal would be to improve the physical communications between the two countries, making it easier for Ethiopia. But this is a very sensitive part of the world in which trade is often the sufferer."
Restoring peace will be a challenge. But as Kenya's President Uhuru Kenyatta said, that deal should allow them to "exchange conflict and insecurity for peace and prosperity".
The first step will be to build a tarmac road linking Nairobi and the Ethiopian capital Addis Ababa, he added. It is due to be completed by September 2016.