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.
|Date of creation:||22 Dec 2008|
|Contact details of provider:|| Postal: Bank of England, Threadneedle Street, London, EC2R 8AH|
Phone: +44 (0)171 601 4030
Fax: +44 (0)171 601 5196
Web page: http://www.bankofengland.co.uk/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Francis E. Warnock & Veronica C. Warnock, 2005.
"International capital flows and U.S. interest rates,"
International Finance Discussion Papers
840, Board of Governors of the Federal Reserve System (U.S.).
- Francis E. Warnock & Veronica C. Warnock, 2005. "International Capital Flows and U.S. Interest Rates," The Institute for International Integration Studies Discussion Paper Series iiisdp103, IIIS.
- 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.
- David Backus & Silverio Foresi & Chris Telmer, 1998.
"Discrete-Time Models of Bond Pricing,"
NBER Working Papers
6736, National Bureau of Economic Research, Inc.
- 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.
- Nicola Anderson & John Sleath, 2001. "New estimates of the UK real and nominal yield curves," Bank of England working papers 126, Bank of England.
When requesting a correction, please mention this item's handle: RePEc:boe:boeewp:0358. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Digital Media Team)
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.