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Understanding the real rate conundrum: an application of no-arbitrage finance models to the UK real yield curve

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  • Joyce, Michael

    ()
    (Bank of England)

  • Kaminska, Iryna

    ()
    (Bank of England)

  • Lildholdt, Peter

    ()

Abstract

Long-horizon interest rates in the major international bond markets fell sharply during 2004 and 2005, at the same time as US policy rates were rising; a phenomenon famously described as a 'conundrum' by Alan Greenspan the Federal Reserve Chairman. But it was arguably the decline in international long real rates over this period which was more unusual and, by the end of 2007, long real rates in the United Kingdom remained at recent historical lows. In this paper, we try to shed light on the recent behaviour of long real rates, by estimating several empirical models of the term structure of real interest rates, derived from UK index-linked bonds. We adopt a standard 'finance' approach to modelling the real term structure, using an essentially affine framework. While being empirically tractable, these models impose the important theoretical restriction of no arbitrage, which enables us to decompose forward real rates into expectations of future short (ie risk-free) real rates and forward real term premia. One general finding that emerges across all the models estimated is that time-varying term premia appear to be extremely important in explaining movements in long real forward rates. Although there is some evidence that long-horizon expected short real rates declined over the conundrum period, our results suggest lower term premia played the dominant role in accounting for the fall in long real rates. This evidence could be consistent with the so-called 'search for yield' and excess liquidity explanations for the conundrum, but it might also partly reflect strong demand for index-linked bonds by institutional investors and foreign central banks.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 358.

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Length: 46 pages
Date of creation: 22 Dec 2008
Date of revision:
Handle: RePEc:boe:boeewp:0358

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Keywords: Yield curve; term premia; conundrum;

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References

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  1. David Backus & Silverio Foresi & Chris Telmer, 1998. "Discrete-Time Models of Bond Pricing," NBER Working Papers 6736, National Bureau of Economic Research, Inc.
  2. Francis E. Warnock & Veronica Cacdac Warnock, 2006. "International Capital Flows and U.S. Interest Rates," NBER Working Papers 12560, National Bureau of Economic Research, Inc.
  3. Gregory R. Duffee, 2002. "Term Premia and Interest Rate Forecasts in Affine Models," Journal of Finance, American Finance Association, vol. 57(1), pages 405-443, 02.
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Cited by:
  1. Joyce, Michael A.S. & Lildholdt, Peter & Sorensen, Steffen, 2010. "Extracting inflation expectations and inflation risk premia from the term structure: A joint model of the UK nominal and real yield curves," Journal of Banking & Finance, Elsevier, vol. 34(2), pages 281-294, February.
  2. Bianchi, Francesco & Mumtaz, Haroon & Surico, Paolo, 2009. "Dynamics of the term structure of UK interest rates," Bank of England working papers 363, Bank of England.
  3. Kaminska, Iryna & Meldrum, Andrew & Smith, James, 2011. "A global model of international yield curves: no-arbitrage term structure approach," Bank of England working papers 419, Bank of England.
  4. Mardi Dungey & M.Tugrul Vehbi, 2011. "A SVECM Model of the UK Economy and The Term Premium," CAMA Working Papers 2011-26, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  5. Kaminska, Iryna & Vayanos, Dimitri & Zinna, Gabriele, 2011. "Preferred-habitat investors and the US term structure of real rates," Bank of England working papers 435, Bank of England.

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