A 2017 50 subject uncut sheet of $1 dollar notes sits on display in Washington, D.C., U.S. (Photographer: Andrew Harrer/Bloomberg)

Bond Rout Could Get Even Uglier If Term Premium Joins the Fray

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(Bloomberg) -- The breakout in 10-year Treasury yields to the highest since 2011 has come with little accompanying increase in the extra premium that investors usually command for locking up cash with the government for a decade.

The benchmark maturity’s yield has risen almost 0.7 percentage point this year, while the term premium is up less than half that amount. What that means is that if this measure of the extra compensation for holding longer-maturity starts catching up, some of the seemingly outlier calls for the 10-year yield may prove prescient.

Strategists say global quantitative easing, pension demand for longer maturities, tame inflation and the Treasury’s policy of favoring shorter-dated issuance are depressing the term premium. But those forces may change, especially if retirement funds’ appetite eases or other central banks join the Federal Reserve in withdrawing stimulus.

“For those seeing the 10-year yield getting to 3.5 to 4 percent, it’s all about a view on term premium rising,” said Priya Misra, head of global rates strategy at TD Securities. “A large part of why term premium has been so low is because money is coming here from the rest of the world,” so if rates abroad become more attractive, the risk is that the premium rises.

For now, Misra expects the prevailing forces to persist, capping the term premium and yields. She forecasts the 10-year yield will end 2018 at 3 percent, compared with 3.09 percent now.

This year’s pattern is a break from years past. Looking at the 10-year yield as the outlook for the fed funds rate and the extra compensation from the term premium, only about 40 percent of the 2018 yield increase has been due to term premium, according to Bloomberg calculations using New York Fed data. In a 2013 episode of spiking yields known as the “taper tantrum,” the premium accounted for about 75 percent of the climb.

Pension demand for duration is evident in the surging amount of notes and bonds split into principal- and interest-only securities, known as strips. Analysts say that companies may also be locking in equity gains and shifting into fixed income, or using some of the windfall from the U.S. tax overhaul to fund pensions.

While this demand may continue, it’s bound to ease at some point, unleashing the cap on the term premium, according to Deutsche Bank AG strategists, who forecast the 10-year yield will end 2018 at 3.25 percent.

“The stripping numbers were encouraging in the sense that they suggest that pension investors have been aggressively addressing their duration needs, and to the extent that equity out-performance is less pronounced going forward, could plausibly have made substantial progress toward their desired portfolio adjustments,” analysts including Stuart Sparks wrote in a note.

“Going forward, we continue to see stable or lower equities as an important pre-requisite for term premium recovery,” they said.

©2018 Bloomberg L.P.

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