Analysts have attributed much of the rise in government bond yields this year to inflationary pressures from the war in Iran and the bullish growth expectations tied to the build-out of artificial intelligence infrastructure.
The rising yields, they say, reflect expectations that the Federal Reserve will keep interest rates elevated to tamp down inflation from higher oil prices and prevent the economy from overheating from the AI build out.
But those analysts say there is a new driver of higher yields, and it is sending more troubling signals.
That driver is called the “term premium,” which accounts for the extra return investors want to be paid for the risk of lending to the government. And based on the moves in the Treasury market, those risks are rising. Last week, the term premium reached its highest level in more than a decade, reflecting investors’ growing concerns about mounting government debts, rising deficits and other fiscal challenges around the world.
Mostly regarded as an obscure concept from the bond market, the term premium is now having a real-word impact.
Investors’ demand for a higher term premium is driving up yields on Treasurys, which influence interest rates on a range of consumer and corporate debt.
Here is what you need to know about it.
What is term premium?
Loosely speaking, there are three main factors that determine government bond yields: the expected level of interest rates set by the Federal Reserve; inflation expectations; and a final, more fuzzy category to account for the additional yield that is not explainable by economic expectations. This is term premium.
A number of factors get lumped into term premium, including but not limited to investor demand to own Treasurys, investors’ perception of the risk of lending to the U.S. government, the ease of buying and selling the government’s debt, and the likelihood that the market will swing sharply higher or lower.
Term premium is estimated by various models produced by banks, economists and others. Based on the Federal Reserve’s preferred measure, term premium ended last week at 0.9 per cent of the overall 10-year yield, which stands at 5.24 per cent.
And that rise in term premium has helped push overall yields higher, even as growth and inflation expectations have held steady. This measure of term premium last week reached its highest level since 2014.
Why has term premium risen?
Analysts said the recent moves point, in part, to a slow global reckoning, as governments that have built up huge debts have started to come under pressure from bond investors to rein in spending and reduce the amount they borrow.
In Europe, these concerns have come to the fore as France battles a fiscal crisis, with worries over its government finances helping to push the country’s 10-year note to 4.85 per cent Tuesday, roughly a percentage point higher from just three months ago. In Britain, the country’s 10-year note has climbed about half a percentage point, to 5.4 per cent, over the same period. And in Germany, the 10-year note has also risen roughly 0.5 percentage points.
Investors have also become increasingly concerned about debts at home. Foreign central banks have already been shedding Treasurys for years, helping push up yields. More recently, analysts said, the government has had to compete for capital with a spate of borrowing from big technology companies, also pushing yields higher.
Analysts also said the Iran war had underscored a perception among investors that the world had become less predictable, with higher yields also reflecting an added “uncertainty premium.”
“Growth has been the story for the full year,” said George Goncalves, head of U.S. macro strategy at MUFG Securities. “The last bit has been about fiscal worries and global markets becoming a concern.”
Why does a higher term premium matter?
The factors behind rising yields matter greatly to companies, investors and the government.
Some factors come with ancillary benefits.
A rise in yields driven by the prospect that the Federal Reserve will raise rates in response to higher growth implies that some companies will have increased profits stemming from that higher growth. Those profits help offset the impact of higher interest rates for companies and help keep stock values high.
Similarly, for the government, a rise in yields stemming from higher growth can help offset worries about rising deficits, with the higher interest costs balanced against higher tax revenues and a growing economy.
But an increase driven simply by investors who are demanding higher returns only weighs on the market.
Analysts at Barclays noted that “a rise in term premium raises the government’s financing cost without automatically improving the revenue base or the economy’s capacity to service the debt.”