Global imbalances and long-term interest rates

Abstract

The bond yield conundrum describes the unusual behavior of US long-term interest rates between 2004 and 2007. These rates’ constancy or decline was considered puzzling, as US monetary policy was restrictive during this period. Theory and historical evidence suggest that such restrictiveness would cause an increase in longterm interest rates. Global imbalances in the form of sustained and increasing international capital flows to the US are believed to be a promising explanatory factor for the interest rate development during this period. A cointegration approach is applied to assess international capital movements’ influence on US long-term interest rates. The inclusion of international capital flows in the analysis can indeed explain a considerable part of the low long-term interest rate environment, which played a decisive role in the recent financial and economic crisis.