Call it the mystery of the rising 10-year yield—and it’s led investors straight to the so-called ‘Treasury Term Premium.’
What’s the term premium? It’s a theoretical representation of the amount of extra yield investors are demanding to compensate for the risks associated with buying a 10-year long-term government bond rather than simply rolling over their bills for a decade. In other words, it’s not based on the expected level of inflation, but on the risk that comes with holding a longer-dated Treasury note or bond.
On Sept. 25, the term premium turned positive for the first time in more than two years, based on the ACM model used by the New York Federal Reserve. It has largely stayed absent or under zero since early 2017. The notable shift has meant investors are demanding more compensation—in this case, yield—for bearing the risk of unexpected changes in the future path of interest rates and other market volatility measures, which can lower the value of their bond or note over time. Long-dated debt is more sensitive to such changes than shorter-term securities.
“Markets now appear to have priced in an extended period of elevated macro uncertainty,” wrote JP Morgan strategist Nikolaos Panigirtzoglou this month, referring to the premium.
And it’s the run up in premiums, which began in July, that is supporting the latest rise in Treasury yields. The 10-year bond yield rose to 0.131 percentage point to 4.84% on Tuesday, its highest level since August 2007. The rise comes as September retail increased by 0.7% month over month, barreling past economists’ expectations for a 0.3% increase, leaving investors feeling jittery about the Fed’s policy path and the economy.
Combine that with the tensions in the Middle East, continued labor strikes, and concerns about the price of oil and it’s easy to see the looming long-term investment risk, rather than simply concerns about the Fed’s interest rate policy.
“We’ve argued from September 19…if not earlier and subsequently that the backup isn’t about ‘higher for longer,’ but increased term premiums, aka required returns on USTs,” Benson Durham, Piper Sandler’s head of global asset allocation, wrote in a note on Oct. 11.
In fact, breakevens on Treasury inflation-protected securities, the amount investors are compensated for possible inflation, have remained virtually unchanged for months, a sign that inflation expectations are anchored.
Why yields are rising might seem unimportant at first. But there’s a big difference between a 10-year that is rising simply to keep up with inflation—it means borrowing costs relative to inflation are remaining consistent—and those that are rising simply because investors see more risk and therefore demand more reward. It matters because it suggests Americans will continue to pay more for their mortgages, credit card balances, and bank loans, and could limit demand for goods and services as uncertainty mounts.
And if yields go too high? It “becomes a situation where we get a sudden stop in the economy, consumption, and spending,” said Torsten Sløk, the chief economist and partner at Apollo Global Management, referring to the worst-case scenario.
Central bank officials have also taken note. When Dallas Fed President Lorie Logan spoke last week, she said higher premiums leave “less need” for hikes as they work to “cool the economy for us.” Vice-chair Philip Jefferson also cited term premiums in his speech on the same day.
The rise may be a result of a supply/demand imbalance. On the supply side, the U.S. government issued $15.73 trillion in government bonds this year through September, up from $12.53 trillion during the same period one year ago. And that debt is anticipated to increase next year as Treasury issuance is expected to rise, on average, by 23% across all maturities to fund the U.S. spending, according to the Treasury Borrowing Advisory Committee.
Demand, though, is a problem. The auction for the 30-year Treasury last week saw the accepted yield nearly four basis points higher than where it had been trading before the auction, a sign that investors are demanding more to buy the bonds. Recent auctions for the 10-year and three-year Treasuries were also weak. That imbalance is reflected in the higher term premiums.
The good news is that even after the recent rise in the term premium to as much as 0.34% points earlier this month, it remains low relative to levels observed during the five years before the 2007-2008 great financial crisis when the average was 1.22%, according to Dow Jones Market Data.
Plus, the term premium is not the only factor defining where the asking yields go. The set of labor market data, including wage growth and job openings, as well as changes in monetary policy influence the trajectory as well.
“If term premia stay on the current track, markets may adjust to a new era of fiscal uncertainty,” wrote Diana Iovanel, economist at Capital Economics. She forecasts the 10-year to fall to settle near 4.65% even though “term premia may remain higher.”
J.P. Morgan strategists also see the term premium rising further, based on an Oct. 2 note, but have “conviction that the peak in yields could be close.”
How the financial markets adjust to the higher term premium in the future could be one factor that determines whether the Fed is able to engineer a soft landing—or something harder.
Corrections & Amplifications:
A misplaced quotation mark attributed words to Benson Durham, Piper Sandler’s head of global asset allocation, that he did not write. It’s been corrected.
Write to Karishma Vanjani at [email protected].
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