Yellen's warning paves way for further bond market volatility

Investors may want to take a closer look at Janet Yellen's comments on the risk of surging interest rates to get a better sense of why she is so concerned.

The Federal Reserve chief cited what is known as the term premium when warning on Wednesday that bonds, as well as stocks, are richly valued, sending prices of both tumbling. Problem is, what to read from the gauge of relative value that has baffled Fed officials and been ignored by investors in the past.

Researchers at the Federal Reserve Bank of New York last year retooled their model, casting aside three decades of data that incorporated estimates for market rates from professional forecasters. The Fed's term-premium model still shows investors are demanding little compensation for the risk that long-term rates will change.

"Long-term interest rates are at very low levels, and that would appear to embody low-term premiums, which can move, and can move very rapidly," Yellen said after a speech in Washington. "We need to be attentive, and are to the possibility that when the Fed decides it's time to begin raising rates, these term premiums could move up, and we could see a sharp jump in long-term rates."

The term premium has been negative off and on since 2012, the year the Fed started its third round of bond buying. The measure was 0.15 percentage point as of May 4, according to the most recent data available from the New York Fed. That is the highest level since December. It touched a 2015 low of negative 0.41 percentage point in January.

"The bond market will be paying closer attention to the idea of the term premium," said Gary Pollack, who manages US$12 billion as head of fixed-income trading at Deutsche Bank's private wealth management unit in New York. "Unfortunately, it will increase the volatility. There's been enough volatility."