Jan 29

Fed paper on why predictive power of yield curve distorted by term premium

by David Harper, CFA, FRM, CIPM

Risk |

This instructive New York Fed paper on term structure of interest rates parses the term spread (= long-term yield - short-term yield)  into two pieces. There are a few ways to slice these rate expectation theories but, according to Level II CFA, expectation theories are either pure or biased:

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Pure expectation theories say the future rate is the expected future spot rate; e.g., the 10-year treasury rate is a consensus estimate of the short rate in about ten years. The glaring flaw is the lack of a risk premium: uncertainty increases over a longer horizon, so the you would expect compensation for the uncertainty (in particular, both real rate risk and inflation risk).

So, the biased theories are more intuitive. They declare that the long-term rate is function of both future expectations and something else. That something else is either: a risk premium to compensate for the longer maturity (liquidity), supply and demand (market segmentation), or a particular variation on supply and demand (preferred habitat). Biased theories are likeable because, if nothing else, they are the general case of the pure expectation theories!

Biased theories justify analyzing the curve in multiple components

Traditional wisdom of course says that an inverted curve predicts a recession. Why? Because the market thinks ahead, and the market associates a recession with monetary tightening. That is, if recession, then tightening. Which implies a lower expected future rate, so the current long term rate must be lower.

But, the problem is, the authors says, "some have argued the yield curve inversion in August 2006 did not signal a recession..." So, they tried to break the analysis into two pieces

  1. The expectations component (= real rate expectations + inflation expectations): the pure expectations part
  2. The term premium component (=inflation risk premium + real rate risk premium): the "remaining difference in yield compensates investors for the risks associated with holding long-term rather than short-term investments."

Their hypothesis is that only the expectations component ought to be predictive of a recession; the term premium ought to enjoy its own dynamic (it is largely a function of uncertainty). Put another way, the term premium under highly uncertain markets may overwhelm and distort the predictive power of the expectations component.

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