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

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.