Rates Spark: The term premium – why so negative?

One of the interesting aspects of the Fed’s minutes was the assertion that the fall in long-term yields from the recent peak came two-thirds from a fall in the term premium and one-third from a taming in rate expectations. That can be broadly confirmed by looking at the Fed’s measure of the 10yr term premium, which peaked out at around 50bp in October 2023, around the time that the 10yr Treasury yield was at around 5%. The 10yr Treasury yield is now just below 4% while the 10yr term premium is back in negative territory at around -30bp. A negative term premium is a problem, as technically it implies no compensation for taking on rolling duration.

So what does this mean? First, a negative term premium is not normal from a theoretical perspective. It has however been featured in recent years, especially during the pandemic years (in particular in 2020 when it was below -100bp for an extended period). A negative term premium essentially means that the level of rates is being dominated by the future path of short-term rates. So when we look at the 10yr yield at 3.9% currently, this effectively is a future mapping of the average path for short-term rates in the next 10 years. There is no compensation for taking on duration. In fact there is negative compensation currently.

That does not mean that 10yr rates cannot fall. They of course can. They can overshoot to the downside at will. It’s just that there is less buffer in 10yr yields than is ideal from a long-term perspective, where you average in on an ongoing basis. You are getting compensation for the changing interest rate environment, and benefit as the Fed cuts rates, and especially to the extent that it might cut by more than expected. But that’s it. Theoretically you could do just as well from a running yield perspective by averaging in on 2yr paper and taking the ups with the downs over the interest rate cycle in the next 10 years.

In a sense this is a remaining anomaly that needs to rectify itself at some point. In many ways there has been a return to normal in the level of rates relative to the pandemic years and the post-Great Financial Crisis ones. The inverted curve that we currently have is not a structural thing, but is perfectly normal at the tail end of a rate hiking cycle. A positively sloped curve is more normal. It can be driven entirely by future rate expectations (as it currently is). But really it should have a term premium. When we think of a normal 100bp curve between a 3% (future) funds rate and a 4% Treasury yield we also infer that there should be a positive term premium.

At some point this will become a discussion point when we get beyond the novelty of the rate cuts to come, and the clearest driver of that will be the realisation that a 6% deficit is something that should command compensation from a bond holder’s perspective. Not so much from an elevation in default risk, but more a weight of a supply one. That said, be aware too of the 3.5% primary deficit (ex-interest rate payments). That’s the bit that jacks up the debt/GDP ratio over time. In fact, this heads to 200% of GDP in the coming couple of decades on unchanged policies.

Now what we are doing with a negative term premium against that in the foreground is anyone’s guess.

The focus for Europe will be on regional inflation readings for December due on Thursday, along with a series of December PMI readings. The likelihood is for some stalling on inflation reduction alongside confirmation of ongoing manufacturing and business weakness. In the US on Thursday we get the pre-payrolls ADP report for December, which for what it’s worth anticipates 125k of jobs creation, slightly below the historical average of 150k per month. We also get jobless claims which are anticipated still in the low 200k territory and indicative of a decent labour market. That said, watch continuing claims as these are on the rise and suggesting a slow creaking of negativity. We will also see the latest Services PMI reading for December, which is seen as unchanged at 51.3. While that is above 50 and technically in an expansion mode, it’s below the average in the area of 54. Don’t expect too much reaction from these data though ahead of Friday’s payrolls report.