There’s a Big Debate Brewing Over a Key Component of the U.S. Bond Market
(Bloomberg) -- Whisper it softly, but this year has witnessed a sea change in markets.
The term premium — or the extra compensation bond traders ask for in return for holding longer-term debt — has turned positive after spending the better part of the last five years moving to or below zero. Another way of putting it, as my colleague Liz McCormick did earlier this year, is that bond investors want to get paid like they used to when lending money to the U.S. government. And while such a request might sound innocuous enough, it has the potential to remove a key support that has helped underpin demand for riskier assets in recent years.
Of course, there’s never much agreement when it comes to the term premium, from what it might mean for the rest of the market to where it ‘should’ be. In many ways, it’s the Rorschach test of the financial world. You can see anything you like in it, and use it to justify (or dismiss) almost anything that’s happening. For instance, when the yield curve inverted back in 2019 in a traditional harbinger of economic recession, people blamed it on low term premia.
Now talk is heating up as concerns over inflation and discussions of future tapering by central banks have combined to spark that bounce in U.S. Treasury yields. Citigroup strategist Matt King kicked off the conversation back in March, arguing that this year’s jump in yields was more about changes in term premia than investors expecting higher interest rates from the Federal Reserve as the U.S. economy recovered from a historic pandemic.
It makes some sense that term premia would rise given that so much of market uncertainty is concentrated at the long-end of U.S. government debt. The Federal Reserve has repeatedly pledged to look through a ‘transitory’ pick-up in inflation and keep rates low, at least in the near-term. And with the U.S. having crossed the Rubicon of fiscal stimulus, there’s plenty of uncertainty about the longer-term impact of a wave of additional debt. As King put it: “One might almost speculate more strongly still: until the bond vigilantes reawaken, politicians have every incentive to continue handing out free money to their citizens. What could be more natural, then, than the return of a few basis points of risk premium?”
Over at Barclays, analysts led by Anshul Pradhan have echoed the sentiment, arguing that the metric remains far too low given the amount of uncertainty now faced by investors. “What that means for markets is that even if the modal expected policy outlook is unchanged, investors should demand a higher than usual term premium for taking duration risk at least until the dust clears and uncertainty subsides,” they wrote this month.
TD Ameritrade analysts led by Priya Misra echoed the sentiment this week, noting that an unwind of central banks’ bond-buying programs will leave government bonds more vulnerable as more of them will need to be snapped up by private investors. She estimates that almost 53% of the net issuance of U.S. sovereign bonds in 2020 was purchased by sovereign banks, with that figure expected to drop to 48% and 44% in 2021 and 2022, respectively. “The pickup in duration supply over time is one of the reasons for our forecast for higher term premiums and higher yields later this year,” she notes.
And then there are those who argue that there may be more unexpected demand for U.S. debt waiting in the wings — perhaps even enough to compress the term premium rather then send it shooting up. Zoltan Pozsar, Credit Suisse’s money market guru and a frequent Odd Lots guest, suggests tapering in the U.S. could be timed with another big event: Just as the Fed retreats from the market, another very large buyer could step in.
As Pozsar put it in research published on Tuesday:
“…and rates don’t have to sell off, provided there is coordination at the Fed. The monetary and regulatory arms of the Fed typically do not coordinate, but never say never. Using the Wells Fargo ‘option’ could help the Fed make taper a smoother affair than the 2013 experience, which wasn’t smooth to begin with. It’s one thing to taper against a boring fiscal backdrop like during 2013, and another to taper against a backdrop painted with cumulonimbi of fiscal issuance – given the fiscal outlook, the Fed should be creative with the Wells Fargo option.
Then there is the consensus problem, which is that everyone expects rates to go up from here, and “if everyone is thinking alike, then somebody isn’t thinking”: the macro reasons for higher rates make sense, but the potential for more Treasury purchases either by the Fed or banks before taper commences, and Wells Fargo deploying $500 billion of balance sheet after taper commences, could set off a rates rally from here. Consider these problems at least as risks…”
So consider the humble term premium. I certainly will be!
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