Views from the Floor - Tighter and Tighter

Why does it seem that everyone, including US Federal Reserve Chairman Jerome Powell, is suddenly focused on the term premium? This sudden attention reflects their attempt to assess whether the surge in bond yields represents a tightening of financial conditions and the impact for monetary policy.

Bond yields can be decomposed into two parts: (i) the expected path of short rates, and (ii) the term premia. If the rise in yields is primarily driven by an increase in term premia, it implies that financial conditions have already tightened to some extent. In such a scenario, there’s less need for further interest rate hikes as higher term premia are already acting as a form of tightening. On the other hand, if there’s been a jump in the expected path of short rates, this might just be a response to growth expectations rising.

The estimation of term premia may appear simple at first by merely subtracting the expected payoff from rolling short-term debt from bond yields. However, the challenge lies in accurately estimating the expected path of short rates, since this is unobserved. Predicting future short rates becomes an intricate puzzle, rendering term premia an inferred concept.

We have two famous academic models to calculate the term premia, the ACM model and the Kim & Wright model, but in the current environment they may both be sending the wrong signals. Both were developed before the ultra-low interest rate environment and persistently negative term premia. These statistical models may not be forward-looking enough, even if the K&W incorporates some survey data.

Both their short-rate expectations are around 4%-5% and that seems unrealistic – does anyone really expect short rates over the next 10 years to average above 4%? Under such tight conditions, growth must be exceptionally strong if the Fed is credibly pursuing maximum employment, which is part of its dual mandate. For reference, the current Federal Open Market Committee (FOMC) median projection for long-run GDP growth is 1.8% and for the long-run Fed Funds Rate it is 2.5%.

A better approach is to incorporate the FOMC’s projections of the Fed Funds Rate into the expected path of short rates. This will make term premia estimates more consistent with sub-2% growth. Figure 1 shows that model applied, with an expectation that the short rate matches the Fed Funds Rate over the next year, then it linearly converges to the long-run projection over the next three years, and then remains constant.

Figure 1. The expected path of short rates may not be as high as traditional models show

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Source: US Federal Reserve, Man Group.

Where this model overlaps with the other two is that for a long time the term premium was negative and since then has been considerably elevated. The big question now is why bond yields are rising and why people want to be compensated for the risk of holding the asset for longer, and the signals it sends to policy makers.

One explanation is that the expected path of short-term rates has risen because of robust growth expectations. And that fuels expectations of further rate increases as the Fed tries to cool the economy. This model suggests this effect is marginal.

The other explanation is a lift in the term premium. This may have been driven by a number of factors:

• There’s been a surge in government bond issuance to cover a massive fiscal deficit in the US, which the IMF forecasts to be 8.8% of GDP alone this year.
• We have also seen quantitative tightening with the Fed selling the bonds it bought during quantitative easing. That’s adding more on the supply side.
• On the demand side we are seeing marginal buyers of bonds being more price sensitive and demanding additional compensation for taking on any inflation risk.
• Furthermore (and related to higher inflation risk), the bond-equity correlation has risen in recent months, affecting bond demand as multi-asset investors feel there’s a decrease in diversification benefits between bonds and equities.

All this points to an increase in the term premium as the reason for the US 10-year yield surging beyond 5% last month and signals that financial conditions could have tightened enough to give the Fed more pause for thought. It seems Jay Powell is of this mind. Last week, in his own words, he admitted that ``financial conditions have tightened significantly in recent months, driven by higher longer-term bond yields, among other factors. Because persistent changes in financial conditions can have implications for the path of monetary policy, we monitor financial developments closely.’’¹ Even though the Fed keep the possibility of further monetary tightening open amid mounting evidence that the US economy remained strong, Powell’s indication that the FOMC also believes the term premium is driving yields upwards, and so may not be in any rush to hike would be good news for investors.

With contributions from Edward Hoyle, Head of Total-Return Strategies, AHL Research and Trading.

1. www.federalreserve.gov/mediacenter/files/FOMCpresconf20231101.pdf