Wall Street’s Got It All Wrong When It Comes to the U.S. Bond Market
(Bloomberg) -- What, exactly, is the bond market telling us?
It’s an age-old question on Wall Street, but one that’s gained newfound urgency as the topsy-turvy markets leave everyone wondering where the U.S. economy is headed. Yet to a small but growing number of analysts, academics and former policy makers, the standard answers may not apply.
The debate centers around the term premium, a notoriously hard-to-understand feature of the U.S. Treasury market. Recently, it’s fallen toward historic levels, setting off alarms among prognosticators who say it is an ominous sign the slowdown in U.S. growth won’t merely be a fleeting event -- and that investors who have poured into risk assets are living in a fantasyland.
The reality may be far less dire. To Jeremy Stein and William Dudley, two former Federal Reserve officials, the drop-off has more to do with a subdued inflation environment and the fact that long-term Treasuries are a natural hedge for investors who have seen their stock portfolios surge in value. Goldman Sachs Group Inc. and Deutsche Bank AG point to hiccups in how the term premium is measured, which may overstate its actual decline. And one of the creators of the most widely followed model says the Fed’s crisis-era bond investments have changed the way the term premium should be understood.
“Term premium is a fancy way for sort of saying, ‘This is the part of the 10-year yield we don’t really understand,”’ said Stein, who is now a professor at Harvard University. That said, historically, the predominant shocks came “from the inflation side. So (you had) a very high term premium. Right now, long-term bonds are seen as a good hedge for stocks.”
Before going further though, a quick primer. Because it’s not directly observable, the term premium has always been somewhat nebulous. Strictly speaking, it’s the extra compensation that buyers need to hold longer-maturity debt instead of successive short-term securities year after year. It’s generally seen as protection against unforeseen and unforeseeable risks -- think inflation and supply-demand shocks.
That margin of safety is one of three components that make up the yield of any given bond, according to former Fed Chairman Ben S. Bernanke. (The other two are the market’s expectations for interest-rate risk and inflation.)
Premium to Discount
As the name implies, the term premium should normally be positive and has been for almost all of the past 50 years. But in recent years, it’s turned into a discount. Last month, it reached minus 0.72 percentage point for 10-year Treasuries, just above the all-time low set in July 2016. The most recent leg down occurred after the Fed shifted to a more dovish stance in January and acknowledged the market’s growing concern over the economy.
And all other things being equal, a lower term premium means lower bond yields. The benchmark note ended at 2.64 percent on Monday, down from a seven-year high of 3.26 percent in October.
More than a few forecasters see that trend as a worrying sign the U.S. economy and corporate earnings aren’t strong enough to justify S&P 500 index’s 18 percent rebound from its December low. Richard Kelly, Toronto-Dominion Bank’s head of global strategy, said it’s “one of the signs that we still aren’t out of the woods.” Evercore ISI’s Dennis Debusschere suggested the deeply negative term premium reflects pessimism about nominal growth.
Indeed, the S&P 500 is coming off its worst week of the year after China dialed back its goal for economic expansion, the European Central Bank downgraded its euro-area outlook and a report showed American hiring slumped. On Monday, U.S. stocks jumped by the most since January, bouncing back from last week’s decline, as retail-sales data boosted confidence in the economy.
Dudley, former head of New York Fed, is inclined to take the long view. The long, steady decline of the term premium, which has brought down U.S. borrowing costs, ultimately has more to do with the Fed breaking the back of inflation. Technological advances, not to mention the Amazon effect, have also made everything cheaper for Americans over the years. Among consumers, the inflation outlook over the next five to 10 years has fallen to 2.3 percent, according to a University of Michigan survey, matching a record low.
As a result, the most pessimistic take isn’t necessarily the right one, he said.
“As long as this inflation regime holds, and we remain in a world where people aren’t worried about budget deficits, then bond risk premiums will probably stay low,” said Dudley, who is now a professor at Princeton University. (He’s also a contributor to Bloomberg Opinion.)
Dudley added that it probably means a recession is unlikely in the near future, even if long-term bond yields fall below short-term rates, a phenomenon that’s historically preceded contractions.
Goldman’s Praveen Korapaty and Binky Chadha of Deutsche Bank say the term premium might not even be as low as some models suggest. While many incorporate an average short-term rate that’s over 3 percent, Fed officials say the current 2.25 percent to 2.5 percent target rate is already close to the lower end of their range of estimates for neutral -- the level that neither slows nor spurs growth. Goldman’s model puts the term premium at minus 0.3 percentage point, roughly half as low as the New York Fed’s popular ACM model.
“These models have the view that the very long-run neutral rate is constant,” said Jonathan Wright, an economics professor at Johns Hopkins University and co-creator of ACM’s predecessor, the Fed’s Kim-Wright model. “Since the crisis, there has been a lot of evidence that the neutral rate has fallen.”
Then, there’s the Fed’s $2.18 trillion of Treasury holdings. A legacy of quantitative easing, the purchases of U.S. government debt are estimated to have reduced the term premium by a full percentage point. While the Fed is now steadily paring its holdings, the opposite hasn’t happened. That’s raised some eyebrows. And since January, Fed officials have started to put the market on notice that the unwind will likely end later this year.
Tobias Adrian, the International Monetary Fund’s financial stability chief and a former New York Fed researcher, says the reason may be structural in nature.
“Markets are very liquid now as opposed to when QE first took place,” said Adrian, who created the ACM model with Richard Crump and Emanuel Moench. It’s not clear the term premium drop-off will be “symmetrically undone with balance-sheet tapering. There is also the issue of how large the balance sheet will be, and its composition, which have implications” for the term premium.
All that leaves Deutsche Bank’s Chadha feeling good about the economy and risk assets, particularly if, as he expects, U.S.-China trade tensions ease. He sees the S&P 500 reaching 3,250 by year-end.
“Maybe the bond market is distorted,” he mused, “because the Fed has done things they have never done before.”
©2019 Bloomberg L.P.