Forecasting the Term Structure when Short-Term Rates are Near Zero

This paper compares the experience of forecasting the UK government bond yield curve before and after the dramatic lowering of short‐term interest rates from October 2008. Out‐of‐sample forecasts for 1, 6 and 12 months are generated from each of a dynamic Nelson–Siegel model, autoregressive models for both yields and the principal components extracted from those yields, a slope regression and a random walk model. At short forecasting horizons, there is little difference in the performance of the models both prior to and after 2008. However, for medium‐ to longer‐term horizons, the slope regression provided the best forecasts prior to 2008, while the recent experience of near‐zero short interest rates coincides with a period of forecasting superiority for the autoregressive and dynamic Nelson–Siegel models.