Treasury term premium turns positive for the first time in two years
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Bond geeks are aflutter over the sighting of a "term premium" on long-term U.S. government bonds — its first appearance in more than two years.
Why it matters: It's another sign the era of slow growth, low inflation, and the easy Fed policy that followed the 2008 financial crisis may be behind us, and people are uncertain about what comes next.
State of play: Yields on the 10-year Treasury note are up sharply, to roughly 4.70%, from less than 3.50% at the start of May.
- The move mostly reflects growing confidence that the U.S. isn't heading for recession, meaning the Fed won't be cutting any time soon, and rates will be higher for longer.
- At the same time, questions remain. How high? And for how long? That's where the idea of the term premium comes in.
How it works: Analysts and financial theoreticians sometimes imagine that you can break down bond yields into two components, like a two-layer cake.
- The first layer is the theoretical yield one could earn by keeping money at the Fed overnight, and simply rolling it over every day for, say, the next 10 years.
- This would basically capture what the Fed is expected to do with the short-term interest rates it uses to implement monetary policy over the next few years.
- The second layer is more nebulous: It's known as the term premium, and it represents the additional yield on bonds that can't be explained by changing expectations about what the Fed is going to do with monetary policy.
- It's basically the premium investors demand if they're going to accept all the uncertainties — such as swings in inflation, government spending, and economic growth — that could occur as their money is locked up in a bond for a decade.
Public service announcement: For the record, these two layers can't be directly observed — but the New York Fed publishes estimates for them, based on economic models. (These models are laid out in detail here.)
- In other words, these are effectively mathematical fictions aimed at quantifying unobservable numbers — so they should be treated with a certain amount of caution.
Between the lines: You can think about the term premium as a measure of how confident or uncertain investors are about predicting the key factors that affect bond yields — inflation, economic growth and monetary policy.
- The premium tends to rise when inflation or the behavior of the Fed becomes tough to predict.
- (Of note: The term premium is distinct from, though closely related to, the oft-cited yield curve, which is sometimes described as the term structure of interest rates — it's another bond market metric that's now in negative territory. The two measures tend to move in the same direction — and indeed, the three-month/10-year yield curve has been moving closer to positive in recent months.)
The big picture: Term premiums went negative in the aftermath of the global financial crisis, as the Fed introduced a bunch of techniques from "forward guidance" to "quantitative easing" aimed at limiting surprises and keeping term premiums low — thereby ensuring low long-term interest rates.
- The fact that inflation was near nonexistent for the dozen or so years before the pandemic also helped investors feel confident about owning longer-term bonds, pushing term premiums lower.
- But since COVID hit, a lot has changed. Government deficits have exploded. Inflation returned. And the Fed is now backing away from some of those policies — like quantitative easing — that kept interest rates reliably low over the last 15 years.
The bottom line: Nobody knows exactly what will come next. And the bond market seems to be waking up to that reality.
