Do Low Bond Risk Premiums Predict Financial Instability?

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One reason that many monetary policy hawks cite for raising the target federal funds rate sooner rather than later is that risk premiums on bonds could spike sharply when the central bank finally begins to tighten its monetary strategy after a long period of accommodation. This is kind of like a patient going through withdrawal after a doctor finally decides that it is time to terminate a prescription for pain medication after major surgery. The theory is that after taking the meds for so long, the patient — the financial markets, in this case — becomes addicted, and tapering the prescription too quickly could lead to painful withdrawal effects.

Many monetary policy experts, particularly doves, have questioned the validity of this theory, but recent data have brought the hawkish perspective to the forefront. Speaking at the International Monetary Fund in Washington, D.C., on Wednesday, Federal Reserve Chair Janet Yellen — generally believed to fall on the dovish side of the spectrum — called attention to some dark clouds on the monetary horizon.

“Corporate bond spreads, as well as indicators of expected volatility in some asset markets, have fallen to low levels, suggesting that some investors may under-appreciate the potential for losses and volatility going forward,” Yellen said.

According to Bloomberg, the Markit CDX North American Investment Guide Index, a gauge of credit worthiness, declined about 1.9 basis points to 55 basis points at the end of June to its lowest reading since October 2007. “Valuations are getting stretched,” Jack Flaherty, investment manager at GAM, a part of GAM Holding AG, told Bloomberg. “You’d rather be early in getting out because when it does turn, it could be more violent than expected.”

However, a recent research paper by the Federal Reserve Bank of Chicago says that the correlation between the risk of financial instability caused by disruption in the bond risk premium and time of exit from an accommodative policy is not necessarily strong. Risk premium is the premium paid by a bondholder for the credit and interest rate risk being carried by that person.