Bilal’s Macroscope: Could Term Premia Shock Add 100bps to Bond Yields? (Yes)

Term premia is the latest thing on the mind of policymakers and investors. In theory, the US 10Y bond yield is made up of the expected future path of Fed over the next 10 years and term premium. The term premium is the extra yield required to entice investors to hold a bond for ten years, rather than holding shorter-term Treasuries and rolling them over ten years. One would expect term premium to be positive, but over the past decade it has gone to almost zero (Charts 1 and 2). This has surprised many, but things could be turning.  

This year, we have seen a big jump in term premium. In January, it was -50bps and today it is +20bps. This means that bond yields have risen by 70bps due to term premium, that is, due to something outside of shifts in Fed expectations. Importantly, this could be just the beginning. We think that the post-GFC bond regime was likely an anomaly, and so we are returning to the pre-GFC regime. This suggests that term premium could go up to the +122bps of the 2000s or the 199bps of the 1990s. This would translate to a potential 100 to 180bps increase in term premium. With bond yields currently at 4.6%, a return of these types of term premia could see yields go to 5.6% or higher without any change in Fed expectations.  

Looking at the key drivers of term premia, we find that all are pointing to an increase: 

1. End of Fed’s QE Removes Bond Bid. One of the biggest factors for the suppression of US bond term premium was likely the large-scale buying of bonds by the Fed since the GFC (Chart 3). This likely distorted market prices. But with the Fed now engaged in QT, the process has gone into reverse, which should see term premium return.  

2. Foreign Central Banks Are Bond Sellers. Over the 2000s and the immediate aftermath of the GFC, foreign central banks were aggressive buyers of US Treasuries thanks to their currency intervention programmes (Chart 4). However, since 2015, they have become sellers as they have drawn down their reserves to support their currencies. While this didn’t immediately see an increase in term premium, this does remove a potential support for US bonds and so should not prevent an increase in term premium.  

3. Worsening US Fiscal picture. Of all the factors cited for this year’s rise in term premium, the worsening US fiscal picture has been the most common one. This makes sense as there is a general relationship where a worsening budget balance does see term premium rise (Chart 5). What makes the current situation especially unusual is the deficit is so large during an expansion phase. This means when a recession hits, the deficit could blow out to even larger levels.  

4. Inflation Volatility Is Here. With term premium, one could get more precise and break it down to real rates term premium and inflation term premium. This allows us to see more clearly how inflation volatility could lead to higher inflation term premium and hence higher overall term premium. Empirically, we can see that the 1970s – a period of high inflation volatility was also associated with high term premium (Chart 6). 

5. Switch in Bond:Equity Correlation. Since the 2000s, the US bond:equity correlation went negative whereby lower bond returns were associated with a stronger stock market and vice versa (Chart 7). This meant that when stocks fell, bonds would rally and deliver positive returns. This acted as a nice diversifier, increased demand for bonds and hence reduced term premium. But that relationship has clearly changed. Last year saw both bonds and stocks deliver negative returns and this year could be similar. The correlation has therefore flipped to positive, which weakens the diversifying properties of bonds. This should lead to higher term premium.  

Bottom line, term premium could continue to rise.  

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)