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  • Cracking the Conundrum
  • David K. Backus and Jonathan H. Wright

Between June 29, 2004, and February 2, 2005, the Federal Open Market Committee increased the target federal funds rate by 150 basis points (bp), or 1.50 percentage points. Over the same period, the long end of the yield curve fell, with the ten-year yield declining by 70 bp and the ten-year (instantaneous) forward rate by more than 100 bp. This pronounced rotation in the yield and forward rate curves caught many by surprise. Then- Federal Reserve chairman Alan Greenspan was one. In his February 2005 testimony to Congress, he noted:1

This development contrasts with most experience, which suggests that . . . increasing short-term interest rates are normally accompanied by a rise in longer-term yields. Historically, even . . . distant forward rates have tended to rise in association with monetary policy tightening. . . . For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.

Bill Gross was another. PIMCO's legendary bond investor advised clients in February 2004 to reduce the duration of their bond holdings, only to see [End Page 293] long-term bonds rally. Thirteen months later he confessed confusion over what had occurred:2

Who would have thought that the bond market could have [done so well]? Not yours truly, nor Alan Greenspan. . . . How then to explain it? . . . I must tell you that we at PIMCO have been talking about this topic for months. We, too, have been befuddled.

The Federal Reserve continued raising the federal funds target thereafter, but the ten-year forward rate continued to fall. In all, the ten-year forward rate fell 170 bp between June 2004 and June 2005 and has rebounded only about 50 bp since then.

If the word "conundrum" from a respected central banker covered red faces in the investment community, other observers had no shortage of explanations for what had happened: some linked the decline in long-term yields to a decline in expectations of long-run economic growth or inflation, others to an increase in the global supply of savings, or to an improvement in the ability of global capital markets to allocate risk efficiently, or to massive purchases of U.S. Treasury securities by Asian central banks and petroleum exporters, or to increased demand for long-term bonds on the part of pension funds, or to reduced supply of long-maturity instruments following the Treasury's 2001 decision (later rescinded) to discontinue auctions of the thirty-year bond, or to a global decline in macroeconomic and financial market uncertainty, perhaps the result of improved procedures for monetary policy or the state of the business cycle.

In this paper we look at several of these proposed explanations, holding each up to a broad array of evidence. The paper's first section is devoted to establishing the facts. Among those we consider key are the following: over the conundrum period, real interest rates fell along with nominal rates; long-term survey expectations of inflation, growth, and interest rates were roughly flat; volatilities and risk spreads fell across a wide range of assets; and distant-horizon forward rates on British and German government bonds fell. The next section considers various interpretations of the facts based on affine bond-pricing models, which allow us to decompose forward rates into term premiums and expected future short-term rates, and then to further parse each into real and inflation components. The models suggest that term premiums declined considerably over the period of interest. The final section considers changes in the macroeconomic environment [End Page 294] that might help explain such changes in term premiums, including a discussion of the explanations mentioned above.

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Figure 1.

Daily Federal Funds Target Rates and Ten-Year U.S. Treasury Yields and Forward Rates, 1985-2006


Here we collect a number of related facts to provide a context for the later discussion. We organize them around a series of topics.

Cyclical Behavior of Interest Rates

The essence of the conundrum is evident in figure 1. During the three preceding episodes of monetary policy tightening, starting in 1986, 1994, and 1999, the ten-year yield on U...


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