Why long-term Treasury yields are more volatile than short-term ones

The primary driver of Treasury yields is expectations about the future course of Federal Reserve monetary policy. This connection is most pronounced at the short end of the yield curve, where yields are tightly tied to near-term interest rate expectations. Nevertheless, monetary policy expectations also matter at the long end. What sets long-term yields apart is their greater sensitivity to shifts in the economic outlook, inflation expectations, and the term premium—the compensation investors require for holding longer-duration bonds.

Monetary policy expectations shape the front end of the curve.

The two-year Treasury yield serves as a key gauge of market expectations about Fed policy. When markets anticipate rate hikes in the near future, the two-year yield typically increases. On the other hand, weak economic data or moderating inflation leads markets to price in rate cuts, causing the two-year yield to decline.

A crucial aspect is that markets anticipate future developments. Treasury yields represent expectations about short-term interest rates over the bond's lifetime. Therefore, yields can shift long before the Fed adjusts its policy rate. This does not imply that markets are always accurate. Occasionally, markets misjudge, but the shift in expectations nonetheless pushes yields up or down based on economic conditions and new data.

Monetary policy expectations continue to influence the long end of the curve.

It is sometimes suggested that the 10-year and 30-year Treasury yields operate independently of the Fed. That view is incorrect. Monetary policy expectations still fundamentally shape longer-term yields, though the effect is more intricate due to the longer economic horizon investors must contemplate.

Long-term Treasury yields consist of two parts: anticipated future short-term interest rates and a term premium. The first component directly ties long-term yields to monetary policy expectations. If investors foresee prolonged restrictive Fed policy or higher short-term rates over the next decade, long-term yields typically come under upward pressure.

The second component accounts for why long-term yields can experience large moves even with minimal changes in federal funds rate expectations. The term premium may increase when uncertainty over inflation grows, since investors require more compensation for holding duration risk. Supply and demand dynamics for Treasuries also affect this premium, though to a very small extent. The term premium is not directly observable or precisely calculable; it evolves with economic conditions.

Long-term yields exhibit greater sensitivity to growth and inflation.

While monetary policy expectations affect the entire yield curve, as maturities lengthen, economic developments have a greater impact on expectations for interest rates over the long term.

Consider a strong US PMI reading that alters growth expectations. Such data could lead markets to anticipate additional Fed rate hikes, lifting the two-year yield. However, the impact on the 10-year yield reaches beyond the next few Fed meetings. Stronger growth may signal a higher equilibrium real rate, firmer demand, and possibly more inflation. If investors believe the economy can support higher rates over the long term, long-term yields could increase more than the two-year yield.

That typically results in a bear steepening, where long-term bonds decline more swiftly than short-term bonds. This occurred after September's US Flash PMI.

Inflation follows the same pattern. A brief rise in inflation may adjust expectations for a few Fed meetings, but a sustained shock can reshape multi-year inflation expectations. Investors might also require a larger term premium due to heightened uncertainty.

The opposite also holds. A worsening growth outlook drives yields down as markets expect monetary easing. That explains why the 10-year yield typically declines more quickly than the 2-year yield ahead of a slowdown or recession. This can occur even when the Fed is tightening, if markets believe the central bank has overtightened and will need to cut rates earlier than anticipated.

That is why longer-term yields are prone to wider fluctuations than shorter-term ones. They incorporate both anticipated near-term monetary policy responses and evolving perspectives on the economy over an extended period.