Like others, I’ve wondered why bond yields have remained so low in recent months. Yes, of course the Fed is in the game big time but what with the taper, the on-going recovery, and forward leaning expectations, I’ve been expecting yields to climb.

And so they have, with the yield on the 10 year up almost 30 basis points since late August (see chart). What explains the increase?

Since we’re looking at a long term bond, there’s a rising “term premium” in play. That’s the additional yield investors’ demand for holding longer-term securities as opposed to just rolling over a series of shorter term securities. If investors believe the economy is gaining steam, they incur “interest rate risk” when locking their money up in a long-term bond, as new issuances with higher yields come onto the market. The term premium is one way bond buyers try to insulate themselves from that risk.

There’s also evidence that all those asset purchases by the Fed reduced term premiums–that was their point–so as the Fed tapers off their assert buys, the term premium should rise.

Expected inflation can also push up yields. But I’m all in with Krugman on this one, as inflation expectations remain well-anchored, as per the Cleveland Fed’s monthly estimates.

That leaves, as noted above, the Fed themselves. We’ll know a bit more about the central bank’s thoughts on all this later next week, including new projections and the connect-the-dots graphs regarding the board’s thoughts about when to expect lift off on rates. But expectations have been a bit more hawkish and that too is nudging on yields.

So I think a rising term premium and expectations regarding higher short term rates as the era-of-zero winds down are pushing up the ten year, and while one never knows, and barring negative shocks, I expect that trend to at least mildly persist.

Source: MarketWatch