A subtle shift in the Treasury market is drawing attention as investors reassess the risks surrounding interest rates, inflation and long-term government debt.
For much of the past year, financial markets have managed to absorb higher long-term interest rates without a major increase in stock-market volatility. Beneath that relative calm, however, an important measure of uncertainty in the bond market is beginning to move higher.
The issue centers on something known as the term premium — the additional return investors typically demand for holding long-term government bonds rather than repeatedly investing in shorter-term securities.
When the economic outlook is relatively predictable, that premium can remain fairly stable. But when investors become less certain about inflation, future interest rates, government borrowing or monetary policy, the compensation they demand for taking long-term interest-rate risk can fluctuate considerably.
That volatility is now becoming more important.
The Bond Market Is Getting More Uncertain
Recent increases in long-term Treasury yields have not necessarily been driven by a dramatic increase in the term premium itself. Instead, the more notable development is that the term premium is becoming increasingly volatile.
There is an important distinction.
Imagine an insurance company that normally charges $1,000 for a particular policy. The price itself might not appear unusual. But if the insurer suddenly begins changing its quote from $800 to $1,200 and back again, that instability tells you something: the insurer has become much less certain about the underlying risk.
Something similar can happen in the bond market.
Investors may not yet be demanding dramatically higher compensation for owning long-term bonds, but rapidly changing estimates of that compensation suggest that confidence about future interest-rate conditions is weakening.
Why Stock Investors Should Care
Bond-market volatility does not remain confined to bonds.
Government bond yields influence borrowing costs and asset valuations throughout the financial system. They affect mortgages, corporate debt, business investment and, importantly, the value investors are willing to place on stocks.
As uncertainty surrounding long-term interest rates increases, investors may begin demanding greater compensation for taking risks elsewhere as well.
One possible transmission mechanism looks like this:
Greater uncertainty about inflation and interest rates → more volatile Treasury yields → higher perceived financial risk → pressure on asset valuations → greater stock-market volatility.
That brings the VIX into the picture.
Often described as Wall Street’s “fear gauge,” the VIX reflects the amount of volatility traders expect from the S&P 500 over the coming month. A low VIX generally indicates relatively calm expectations, while a rapidly rising VIX signals expectations of larger market swings.
Historically, periods of significant instability in interest-rate markets have sometimes coincided with, or preceded, increases in equity volatility.
Bonds and Stocks Are Sending Different Signals
The particularly interesting development is the apparent divergence between the two markets.
The bond market has been experiencing greater uncertainty surrounding interest rates, while equity volatility has remained comparatively contained.
That does not automatically mean stocks are about to fall. Markets can remain disconnected for considerable periods, and rising bond volatility alone does not predict a stock-market correction.
But the divergence is worth watching.
If Treasury-market uncertainty continues increasing, investors could eventually become less comfortable maintaining relatively low expectations for stock-market volatility.
What Investors Should Watch
The key question isn’t simply whether Treasury yields rise or fall. The stability of those yields may matter just as much.
A gradual increase in yields caused by improving economic growth is very different from large, unpredictable movements caused by uncertainty over inflation, fiscal policy or future interest rates.
For that reason, investors may want to pay attention not only to the level of long-term rates, but also to how violently expectations about those rates are changing.
The current signal is therefore better viewed as a warning light than a prediction.
The bond market appears to be becoming less certain about the price of long-term risk. The stock market, meanwhile, remains relatively calm.
Whether that calm persists could depend increasingly on what happens next in the Treasury market.
