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Good morning. How will markets digest the breakout of war in the Middle East? Minds immediately leapt to the oil price, and to memories of the 1973 Yom Kippur war, another surprise attack on Israel. The oil embargo that followed ultimately led to the unanchoring of US inflation and forced the Federal Reserve, under Paul Volcker, to crush the economy. Is that antecedent the right one? Let us know your thoughts: email@example.com and firstname.lastname@example.org.
The term premium
Unhedged has written several times about the rising term premium, an important, and concerning, attribute of the recent sell-off in long bonds. The term premium is the extra dollop of yield investors get for holding long-dated Treasuries, as compensation for taking on interest rate risk. Think of it as the difference in yield between a 10-year Treasury and rolling over the expected one-year rate 10 times over a decade.
Because the term premium can’t be observed, it is estimated. The main two methods both involve running regression models on different parts of the yield curve. One approach (called the ACM model, after its authors’ names) does so only using data on yields, and the other (the K&W model) mixes yields data with forecaster expectations of short-term rates. Results sometimes differ, but lately both approaches have told the same story. The term premium appears to be positive for the first time since 2017:
If the term premium reverted to its 30-year average, it could add something like 80 basis points to the 10-year yield, leaving it not far from 6 per cent. The ACM and K&W models may even be too sanguine on how far the term premium could increase, says Michael Howell of CrossBorder Capital.
So it matters why the term premium is rising right now. On Friday, we came up with several potential reasons, and over the weekend readers chipped in a few more (we’ve tried to keep them distinct but there is some overlap):
Expected rate volatility is higher, perhaps because expected inflation volatility is higher. Strong economic growth, (some) signs of sticky inflation and a Fed insisting on higher for longer all cloud the rate outlook. There is also the live possibility of structurally higher volatility in inflation, such as from climate-related supply disruptions or geopolitical flare-ups. Investors will want compensation for that volatility. “If there’s less certainty around long-term rates, that deserves more of a term premium,” says Gordon Shannon, investment grade portfolio manager at TwentyFour Asset Management.
Uncertainty around US solvency and/or political stability is higher. In its US sovereign credit downgrade in August, Fitch blamed “a steady deterioration in standards of governance”, raising fears that political dysfunction might someday cause a missed bond repayment. As an explanation for a higher term premium, this is hard to believe. Given the global appetite for safe assets, as investments and as collateral, plus the US’s singular role in producing loads of them, the Treasury market is too big to fail. Unless and until a payment actually is missed, investors will probably look through hypothetical US credit risk.
Treasury supply has risen sharply, and will keep rising. Extraordinary peacetime fiscal deficits require extraordinary bond issuance. As our colleagues Kate Duguid and Mary McDougall report, net Treasury issuance so far this year is already the second-highest on record, though well short of the record Treasury flood in 2020. After some surprisingly chunky bond auctions in the third quarter, many market-watchers expect supply to continue growing fast next year.
Foreign Treasury demand is not rising. At least, not at a pace that can offset the surge in supply. Some have raised the alarm about falling Japanese and Chinese Treasury purchases, but Brad Setser, one of the closest watchers of global capital flows data, argues this is a misreading. He shows nicely in the chart below that demand is OK; the story is largely about supply:
The marginal buyer may be growing more price-sensitive. Classic Treasury buyers who don’t much care about price include the Fed, US commercial banks and foreign central banks. But the Fed is running its quantitative tightening programme, commercial banks are trying to reduce duration risk and foreign Treasury demand isn’t rising (see previous bullet). In their place, more price-conscious asset managers, hedge funds and pension funds are stepping in, Jay Barry of JPMorgan points out in a recent note. His chart:
Marginal buyers who are more price sensitive and who face a wave of supply presumably have more power to extract a higher term premium. However, we’d point out that this seems more a backdrop force than a proximate cause of the recent Treasury term premium rise. As the chart above shows, price sensitivity has been on the rise for some time.
The balance of risks for bonds has shifted. The four-decade bond bull market is widely believed to be over, so investors want more coupon in place of the expectation of capital appreciation. “The relative risks of being pinned at the zero lower bound have fallen (Fed has plenty of room to cut rates) and risks of higher inflation have risen. Following the GFC risks were much more one-sided and bonds were seen as a hedge for Japan-like outcomes,” points out one esteemed reader. Like with buyer price sensitivity, though, we’re not sure why this would have started applying just now.
The drumbeat of QT continues. JPM’s Barry argues that the Fed’s balance sheet run-off has contributed to a rising term premium. He starts by noting that in the post-2008 quantitative easing era, the yield curve’s shape correlated tightly with the term premium. As the Fed bought long bonds, it pushed prices up and yields down, flattening the yield curve throughout the 2010s. At the same time, the 10-year term premium fell. Now, Barry expects the opposite: QT should re-steepen the curve, which in turn should lift the term premium.
None of this suggests we ought to expect something catastrophic, such as a Treasury market buyers’ strike. The Treasury market’s global centrality makes a true breakdown unthinkable; anything approaching one would force the state to act. Rather, as Shannon put it to us: “It’s all a question of price. There are no absolutes.”
One good read
“Netanyahu’s entire strategy towards the Palestinians now looks like a failure.”