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 due 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.
Fancy Terminology
“ 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.)
What’s a ‘term premium,’ and where did mine go?: QuickTake Q&A
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 2.63 percent last week, down from a seven-year high of 3.26 percent in October.