{"id":4056,"date":"2023-10-21T20:06:50","date_gmt":"2023-10-21T20:06:50","guid":{"rendered":"https:\/\/infundpros.com\/markets\/fed-says-bond-markets-term-premium-is-the-reason-behind-rise-in-treasury-yields-why-investors-should-take-it-with-a-dose-of-caution\/"},"modified":"2023-10-21T20:06:51","modified_gmt":"2023-10-21T20:06:51","slug":"fed-says-bond-markets-term-premium-is-the-reason-behind-rise-in-treasury-yields-why-investors-should-take-it-with-a-dose-of-caution","status":"publish","type":"post","link":"https:\/\/infundpros.com\/?p=4056","title":{"rendered":"Fed says bond market\u2019s term premium is the reason behind rise in Treasury yields. Why investors should take it with a dose of caution."},"content":{"rendered":"
U.S. Federal Reserve officials and some investors are increasingly focused on something that can\u2019t be easily explained by the economy or monetary-policy expectations as a likely driver for the relentless selling of government bonds that has brought long-term Treasury yields to their highest levels in more than 16 years.\u00a0<\/p>\n
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The so-called term premium of Treasurys, or the compensation that investors require for bearing the risk of holding longer-dated bonds, has taken center stage as some Fed officials started to think a rising term premium has driven much of the recent surge in 10-year \n BX:TMUBMUSD10Y \n and 30-year Treasury yields \n BX:TMUBMUSD30Y \n since late September. <\/p>\n
The rising Treasury yields are believed to do some of the \u201cheavy lifting\u201d of cooling the economy, so the central bank may have less need for additional monetary policy tightening. <\/p>\n
See:<\/strong> Long-term U.S. Treasury yields may resume their march higher despite recent bond-market swings, BlackRock says<\/p>\n
The idea of term premium is that investors should receive extra yield for taking the duration risk of longer-term Treasurys because they can always choose to continuously roll over shorter-term bills. A high term premium implies that owning, for example, a 10-year Treasury note should get better return than rolling a 1-year Treasury bill for ten years. <\/p>\n
Dallas Federal Reserve President Lorie Logan recently suggested that her models show that \u201cmore than half\u201d of the total increase in long-term yields since July reflects rising term premiums, which made her less inclined to raise policy interest rates again this year. However, the size and persistence of the contribution are still subject to uncertainty, she said.\u00a0<\/p>\n
Fed Chair Jerome Powell also nodded to the term premium as a driver for yields. \u201cIt\u2019s really happening in term premiums\u2026 and not principally a function of the market looking at near-term fund rates,\u201d he said Thursday at the Economic Club of New York on Thursday. <\/p>\n
See:<\/strong> Powell says more strong data like in September could warrant further interest-rate hikes<\/p>\n
However, measuring the term premium is where things get tricky since it can\u2019t be directly observed or calculated. The so-called ACM model by the New York Fed shows the term premium for the benchmark 10-year Treasury turned positive for the first time in almost two years in late September.\u00a0<\/p>\n
The premium tends to rise when key factors that usually affect bond yields such as inflation, economic growth, or the Fed\u2019s monetary tightening path become tough to predict.<\/p>\n
See: <\/strong>Here\u2019s a chart on one of the biggest factors behind rising yields this week<\/p>\n
\u201cThe whole term premium is a bit amorphous,\u201d said Dec Mullarkey, managing director of investment strategy and asset allocation at SLC Management. \u201cWe all buy into it [the idea] \u2013 if you\u2019re holding the 10-year Treasury, you\u2019re gonna have more price volatility, shouldn\u2019t you get compensated for that \u2014 but no one can put a firm number on it [term premium].\u201d\u00a0<\/p>\n
In recent weeks, debate around whether the term premium could really explain the rising yields has intensified.\u00a0<\/p>\n
Mullarkey said the reason Logan and other Fed officials attributed the surging yields to term premiums is they want to show \u201cthere\u2019s nothing changed in their previous communications\u201d on their inflation expectations and the path of the interest rates, because a rising term premium can\u2019t be explained by either of these market-moving factors.<\/p>\n
Logan thinks the Fed policy is \u201cas stable as it was.\u201d Therefore, \u201cshe bundled it into the idea of the term premium, which makes sense when we hear it, but when you try to burrow in and try to understand it further, that\u2019s when the math gets tricky and the thing falls apart, and it\u2019s really just a concept,\u201d Mullarkey said.\u00a0<\/p>\n
Ralph Axel, interest rates strategist at Bank of America Global Research, also found the Fed\u2019s argument unconvincing as the term premium, as an overall concept, does have some challenges.\u00a0<\/p>\n
Theoretically, the term premium should not remain elevated for long periods of time in the presence of buyers who are able to buy and hold long-term Treasurys to maturity to take advantage of it. In other words, the term premium represents \u201cfree lunch\u201d for buy-and-hold accounts because if the premiums are high, it would represent a transfer of income from those who can roll overnights to those who cannot, Axel said in a Wednesday note.\u00a0<\/p>\n
Meanwhile, historical data shows a high term premium does not live up to its intended purpose, and it doesn\u2019t typically correspond to better performance of longer term yields compared with the rate of rolling short-term Treasury bills. <\/p>\n
For example, when the 5-year Treasury\u2019s \n BX:TMUBMUSD05Y \n term premium was historically high between 2005 and 2008, the term rate didn\u2019t perform well versus rolling overnights for five years. However, when the term premium was low in 2004 and 2011, the term rates for 5-year Treasury beat overnights significantly, Axel and his team said.\u00a0<\/p>\n
See:<\/strong> Potential benefit of owning stocks over bonds has shrunk to its lowest level in 21 years<\/p>\n
Axel also found that the term-premium models are distorted by the slope of the 10-2 year Treasury yield spread, meaning that the models are not measuring just a term premium but are mostly reflecting the slope of 2y-10y yield curve, which in turn is a function of the overnight Fed policy rate.\u00a0<\/p>\n
The chart below shows the 10-year Treasury\u2019s term premium looks \u201cremarkably\u201d like the slope of the 2y-10y yield curve, which is odd as the curve flattened and the term premium declined between 2016 and 2018 when the Fed hiked interest rates. <\/p>\n
\u201cThis runs strongly counter to the increase in inflation risk and the worsening of the deficit outlook in recent years,\u201d Axel said. \u201cThe term premium only began to rise recently when the curve started steepening in June 2023. We believe the curve steepened because the magnitude of Fed cuts priced into 2024-25 were reduced as the resilient data reduced the probability of a hard landing.\u201d<\/p>\n
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Axel and his team encourage their clients to take the standard term-premium measures \u201cwith a dose of caution.\u201d While some of the sharp increase in yields since July can be attributed to higher term premium, they think the recent yield move is mostly due to pricing out of expected Fed interest rate cuts on the back of ongoing economic resilience.<\/p>\n
U.S. Treasury yields finished lower on Friday, pulling the 10-year rate away from 5% which it briefly touched on Thursday afternoon, according to Tradeweb data. The yield on the 10-year Treasury fell 6.3 basis points to 4.924%. For the week, it rose 29.6 basis points, according to Dow Jones Market Data. The yield on the 30-year Treasury fell 1.4 basis points to 5.087%.<\/p>\n<\/p><\/div>\n