Long-term Federal Bond Rates and the Risk Premium

James Hamilton summarizes a recent paper by Glenn Rudebusch, Eric Swanson, and Tao Wu:

the recent diverging trend between short-term and long-term yields has been fairly remarkable. In a typical episode of monetary tightening, as the Fed increases the fed funds rate, long-term yields also rise, though not as much. For example, between January 1994 and February 1995, a 3% increase in the fed funds rate was associated with a 1.7% increase in the 10-year Treasury yield. By contrast, when the Fed increased the funds rate from 1% in June 2004 to 4.25% in December 2005, the rate on 10-year Treasuries fell from 4.7% to 4.5%. One explanation is that there has been a dramatic drop in the term premium, that is, a decline in the extra expected return that investors require in order to hold long-term securities. An objective summary of the risk that investors perceive from holding long-term bonds comes from the prices of option contracts on Treasury bonds. The lower the price investors are willing to pay for an option that only delivers if there is a big move in interest rates, the safer the long-term investment appears. The implied volatility from these option values (the Merill-Lynch MOVE index) has fallen quite dramatically since 2003, the same time that the yield curve has been flattening and now inverting.

We had discussed another angle to the relationship between long-term rates versus short-term rates – that being that canard that Social Security will soon be bankrupt:

we can’t cash in Trust Fund bonds because of trading restrictions. Is this some astute point as those who privately hold Federal bonds can trade them in? Well, let’s think about how market prices respond to default risk. Oh yea, the market prices of long-term bonds would fall, which would mean that their yields would be higher. So let’s check with the reporting of market rates from the Federal Reserve …

Rudebusch, Swanson, and Wu’s paper does not even consider default risk – likely because such risk is seen by market participants as non-existent.