Fed says bond market's term premium is the reason behind rise in Treasury yields. Why investors should take it with a dose of caution.

By Isabel Wang

Bond market's term premium appears to be the primary culprit for rising Treasury yields. What it is and why the concept is challenging.

U.S. Federal Reserve officials and some investors are increasingly focused on something that can't 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.

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 BX:TMUBMUSD10Y and 30-year Treasury yields BX:TMUBMUSD30Y since late September.

The rising Treasury yields are believed to do some of the "heavy lifting" of cooling the economy, so the central bank may have less need for additional monetary policy tightening.

See: Long-term U.S. Treasury yields may resume their march higher despite recent bond-market swings, BlackRock says

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.

Dallas Federal Reserve President Lorie Logan recently suggested that her models show that "more than half" 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.

Fed Chair Jerome Powell also nodded to the term premium as a driver for yields. "It's really happening in term premiums... and not principally a function of the market looking at near-term fund rates," he said Thursday at the Economic Club of New York on Thursday.

See: Powell says more strong data like in September could warrant further interest-rate hikes

However, measuring the term premium is where things get tricky since it can't 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.

The premium tends to rise when key factors that usually affect bond yields such as inflation, economic growth, or the Fed's monetary tightening path become tough to predict.

See: Here's a chart on one of the biggest factors behind rising yields this week

"The whole term premium is a bit amorphous," said Dec Mullarkey, managing director of investment strategy and asset allocation at SLC Management. "We all buy into it [the idea] -- if you're holding the 10-year Treasury, you're gonna have more price volatility, shouldn't you get compensated for that -- but no one can put a firm number on it [term premium]."

In recent weeks, debate around whether the term premium could really explain the rising yields has intensified.

Mullarkey said the reason Logan and other Fed officials attributed the surging yields to term premiums is they want to show "there's nothing changed in their previous communications" on their inflation expectations and the path of the interest rates, because a rising term premium can't be explained by either of these market-moving factors.

Logan thinks the Fed policy is "as stable as it was." Therefore, "she 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's when the math gets tricky and the thing falls apart, and it's really just a concept," Mullarkey said.

Ralph Axel, interest rates strategist at Bank of America Global Research, also found the Fed's argument unconvincing as the term premium, as an overall concept, does have some challenges.

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 "free lunch" 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.

Meanwhile, historical data shows a high term premium does not live up to its intended purpose, and it doesn't typically correspond to better performance of longer term yields compared with the rate of rolling short-term Treasury bills.

For example, when the 5-year Treasury's BX:TMUBMUSD05Y term premium was historically high between 2005 and 2008, the term rate didn't 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.

See: Potential benefit of owning stocks over bonds has shrunk to its lowest level in 21 years

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.

The chart below shows the 10-year Treasury's term premium looks "remarkably" 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.

"This runs strongly counter to the increase in inflation risk and the worsening of the deficit outlook in recent years," Axel said. "The 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."

Axel and his team encourage their clients to take the standard term-premium measures "with a dose of caution." 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.

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%.

-Isabel Wang

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10-21-23 1137ET

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