For all the very real human tragedy, it’s always been hard to say exactly how these events would affect the wider global economy and, therefore, the long-run interest rate environment. Some observers may have been scared by the run-up in oil prices after Hamas’s attack on southern Israel, while others might have focused on the notion that spreading military conflicts risked hastening the move toward deglobalization, essentially putting the deflationary effects of offshoring and vibrant international trade networks in reverse.
But the initial spike in oil prices has been completely wiped out, and the deglobalization link always involved a lot of storytelling and guesswork. Meanwhile, the worst-case scenario in which the Israel-Gaza conflict spread to involve the U.S. and Iran seems to have faded. One quantitative measure of daily geopolitical risk—an index created by Dario Caldara and Matteo Iacoviello—suggests that market uncertainty has indeed abated.
The other piece of the term-premium puzzle is the gaping U.S. budget deficit and the related glut of debt issuance. The deficit, of course, is clearly an issue that fiscal authorities in the U.S. must address in the long run, and it has obvious ramifications for bond yields. Understandably, many people believe that credit risk is a silly notion in the U.S., because the government controls the world’s reserve currency. It can print its way out of any pickle. But whether you see the deficit as a credit issue or an inflation issue, it’s clearly still a problem.
A problem for today? Probably not. At some point, the nation needs to either bump up against some extraordinary good luck—a stellar run of strong productivity and economic growth, for instance—or our leaders will have to move to a more sustainable fiscal trajectory. Yet the experience of one even more indebted nation—Japan—suggests that this state of affairs can drag on for a considerable period of time.
As bad as the U.S. deficit has looked in 2023, it has already begun to narrow a bit as deferred tax revenues (Californians got a delay due to winter storms) have come in. No doubt, the problem would get ugly again quickly if interest rates stay higher than economic growth (driving up interest expenses faster than tax revenue), but the gradual normalization of Fed policy presumably starting next year should allay those concerns.
Decades of recent U.S. history show that bondholders generally agree that the U.S. isn’t a credit risk. Except for a brief period in the early 1980s, bond yields and term premia have shown essentially no relationship to the size of the budget deficit. Once in a blue moon, a compelling narrative changes that, as was the case in the early part of the Reagan administration, when investors worried that planned tax cuts and spending initiatives were wrong for an economy still contending with inflation and high interest rates.
At some point, bond vigilantes may lose patience again, selling securities to protest irresponsible fiscal policy and forcing change. But the experience of the past several weeks suggests that we’re not there yet.
So What?
No one knows what the “right” term premium is, of course. Several models put the 20-year-average premium before the Covid-19 pandemic at close to one percentage point, and that seems like as good an assumption as any for something so inherently unpredictable.
If interest rates are set to average around 3.1% over the next decade (inclusive of current rates) and the term premium settles in at around 100 basis points, then 4.1% is a reasonable guesstimate for the 10-year Treasury yield. At 4.16% at the time of writing, we’re not very far off at all. So the days of stock-like total returns in Treasury markets may be behind us for a while. That’s the thing with markets driven by sentiment and stories; if you blink, they leave you in the dust. But if, instead, the market is indeed moving into a period of more sober analysis, then boring and predictable may just be a welcome development.
Jonathan Levin is a columnist focused on U.S. markets and economics. Previously, he worked as a Bloomberg journalist in the U.S., Brazil and Mexico. He is a CFA charterholder.