Mike Dolan

LONDON (Reuters – When is the right time? Investors are used to requesting additional compensation for security held over many years. This is in order to protect long-term unknowns. It makes it seem a little strange that there’s no premium on bond markets.

The disappearance of the term premium in U.S. Treasury bond 10-years over the past five years puzzled policymakers as well as analysts. It was blamed either on lower inflation expectations, or distortions in central bank bond-buying.

It’s not easy to predict the future, but it has been difficult if never.

After the pandemic, which caused extreme swings in economic activity as well as supply bottlenecks, inflation has reached a 40 year high. The problem was then exacerbated by the spike in energy prices caused by war in Ukraine.

U.S. Federal Reserve Bank and other central bankers are scrambling for super easy monetary policy to help. Not knowing if to concentrate on reining prices down or dealing with what Bank of England chief Andrew Bailey called a “historic shock” to household incomes, they have been trying to find a way to do both.

Similar to the last quarter, bond yields are on the rise. However, bond funds are experiencing one of the worst quarters for more than twenty years. Some measures of Treasury volatility have reached their highest level since 2008’s banking crisis.

However, the term premia estimates embedded in bond market markets are still very negative. This is important because it reflects a host of crucial bond market signals. Not least, the inversion of U.S. Treasury yield curves between short- and long term yields. It has been a predictor of recessions in the past.

Sonal Desai (fixed income chief at Franklin Templeton) stated that “the 10-year term premium barely budged, even though inflation spiked up to 8%,”. Investors may think that the Fed might reexamine its policies once assets prices show a significant correction.

Desai stated that markets still underestimate the extent of the Fed’s monetary policy tightening in the future. He also said that the expectation of more Fed hikes than two percentage points this year will likely mean real policy rates remain negative through December, even though inflation is at 5%.

Graphic: US ‘term premium’ stays negative-https://fingfx.thomsonreuters.com/gfx/mkt/byvrjbqamve/One.PNG

Graphic: Fed contrast between Yield Curve and Near Term Forward Spread-https://fingfx.thomsonreuters.com/gfx/mkt/lbvgnmlxwpq/Two.PNG

BUMP INTO THE NIGHT

So, what is the problem with the term premium and the word beef?

The Treasury term premium, in effect, is used to calculate the extra yield required by investors to buy and hold a 10 year bond to maturity. This compares to purchasing a 1 year bond and then rolling it over for 10 more years using a new coupon.

The theory is that it will cover all possible things over a period of ten years. This includes credit risks and political risk. But it also reflects uncertainties about the future Fed rate and inflation expectations.

You would assume that investors don’t care if the 10-year note is held today, or rolled 10 one-year bills.

The New York Fed still has a very negative measure of the 10-year premium of -32 Basis Points. It seems that investors are more comfortable holding longer-duration assets.

The premium rebounded to positive during the second half of 2017 but has remained at zero since 2017, oddly considering the Fed’s recent attempt to balance its books.

The persistent, puzzling loss of term premium below zero brings it back to 1960s and not to inflation-ravaged 1970s as everyone thinks we are back in.

This is a crucial issue now that there’s heated debate over the inversion of 2-10 yield curve. Many argue that it signals a less clear signal about coming recession because of its distortion by disappearance of term premium.

Without a long-term premium, the yield curve for the long term is simply a reflection long-run expectation of policy rate expectations. There will undoubtedly be retreat if inflation is controlled by the Fed over the next 2 years.

Steven Sharpe, an economist at the Fed Board, and Eric Engstrom late last week dismissed speculations that the market was obsessed with inverting 2-10 year yields as a sign of recession.

A blog called “(Don’t Fear) the Yield Curve” stated that the near term forward rate spreads over 18 months provided more information about the possibility of a recession. They were just as reliable and accurate with time, but are heading in the opposite direction.

They resisted the 2-10s because it included a lot of data about the world that was beyond two years. This information is less reliable for economic signals and has been “buffeted with other important factors like risk premiums on long term bonds.”

However, what is the likelihood of a premium return in the future?

If its long-term bond purchases have distorted term premia, then the Fed’s balance sheet rundown or quantitative tightening would likely be an ideal candidate.

However, the Fed’s last attempt to implement QT in 2017-19 failed. Morgan Stanley (NYSE: ) believes it will take some time before short-term bond balances are allowed to roll off, and that mature bonds can be sold.

“QT cannot be the opposite of QE. Asset sales are.”

Maybe the world hasn’t really changed much in recent years – with declining potential growth, negative real interest rates, aging demographics and excess savings. Investors seem to believe that once this storm passes, they will be able to dominate again.

Graphic:Fed balance sheet and maturities- https://fingfx.thomsonreuters.com/gfx/mkt/lgvdwqobapo/Three.PNG

The author serves as editor-atlarge at Reuters News for markets and finance. These views are solely his.

(by Mike Dolan. Twitter: @reutersMikeD. Jane Merriman edits