Brace for Steeper Yield Curves as the Wolves Return

Ultra-accommodative monetary policy by the U.S. Federal Reserve and other central banks has created many market distortions, among them the disappearing term premium, or the extra compensation investors demand to bear the risk of lending money for longer periods of time.

With risk largely mitigated, the term premium disappears. The drop in risk has everything to do with monetary policy since 2008. Just as important as the central bank “put,’’ which took realized risk out of the financial system by creating a safety net for investors, is the distortion in risk levels caused by low interest rates. Here's how that worked: As bond yields plummeted, investors sought alternative ways to earn income and a popular choice was to "sell" volatility, which took perceived risk out of the system by pushing measures of implied volatility to historic lows.

This was inevitable, given the economic forces of substitution whereby imbalances in capital markets are seldom isolated: central banks pushing rates to abnormal lows forced implied volatility to abnormal lows. With both realized and perceived risk disappearing, it is no surprise that the term premium also vanished.