Exercise caution when analyzing bond yields as an investor

If I were reincarnated, I would come back as the yield curve because it seems to cause havoc no matter which way it swings. The yield curve has been making waves lately, especially when it inverted last October. This occurs when yields on long-term bonds fall below those on short-term ones, and it’s often seen as an ominous sign that a recession is coming.

But lately, the curve has been “disinverting” rapidly. The 10-2 spread, which measures the difference between ten- and two-year bond yields, has been shrinking, with only 0.3 of a point between the two yields. This could be interpreted as a positive sign, but in the world of market zoology, it’s viewed more as a “bear steepener,” meaning it’s still causing panic.

The rising term premium, which is the additional yield investors require to hold longer-dated securities, is causing the latest scare. Estimates by the New York branch of the Federal Reserve show that the premium on ten-year bonds has risen by 1.2 percentage points from its lowest level this year, which has led to a surge in long-term yields.

Term premium risks

However, the term premium is a difficult thing to measure and must be treated with caution. It’s not something that can be directly quantified; analysts have to estimate it based on various other factors within the financial system.

John Cochrane of Stanford University’s Hoover Institution points out that estimating risk premiums is easier at short maturities, but as you move along the curve, making calculations becomes increasingly reliant on assumptions about future short-term interest rates.

And when it comes to changes in the yield curve or term premium, there’s not much history to draw from for comparison. In the past 40 years, meaningful periods of bear steepening have occurred only eight times, and the correlation with subsequent recessions varies widely.

Yield curve uncertainty

So, attributing bond yields to one factor becomes a challenge, and inferring the future from the shape of the yield curve is more like reading tea leaves than engaging in a scientific endeavor.

However, regardless of the reasons for the surge in long-term bond yields, it spells bad news for American companies that want to borrow for the long term, as well as borrowers who are considering new mortgages tied to 30-year interest rates.

Ups and downs in the bond market are always hard to interpret, so no matter how you look at it, uncertainty is the only thing that’s certain in the financial world right now. So, before reading too much into the subject, start with these simple realities; they’ll serve as a better guide through the madness.

For more insightful musings from our columnist on financial markets, Buttonwood, check out the following articles: “Why investors cannot escape China exposure” (Oct 5th) “Investors’ enthusiasm for Japanese stocks has gone overboard” (Sep 28th) “How to avoid a common investment mistake” (Sep 21)