Term premium and volatility

There has usually been a nice relationship between the steepness of the yield curve and volatility. Call it a liquidity premium. Higher volatility was often associated with a steeper curve. When volatility declined or the liquidity premium declined, there would be a flattening of the yield curve. The relationship has not held up in the last year. Bond volatility has fallen off a cliff since the highs at the end of 2008, yet we have seen the yield curve get steeper and no decline in sight. So what is going on?

There is not an inflation effect because price increases have been tame even with the recent increase in PPI. In fact, after an inflation expectation scare. The market seems to believe we will be in a benign inflation environment.

A more likely scenario is a price pressure effect from government debt. The relationship between debt and the yield curve has been measured to be positive but slight. However, this was under pre-2008 conditions. The size of debt has been multiples larger. Yet, even this story has problems. Up until recently, the debt markets have not issued a significant amount of private deals so it is harder to argue for a crowding of private capital.

The steep curve story will be one of the more important fixed income mysteries to be unraveled in 2010.