Market Strategist, Greater China
Summary: The surge in bond yields, exemplified by the 10-year Treasury's 47-basis-point spike since the September FOMC, isn't solely due to the Federal Reserve's "higher for longer" rhetoric. Delving into the intricate world of term premiums, this article dissects the factors driving yield movements. Historical patterns reveal that yield surges have been shaped by various elements, from rate expectations to term premium fluctuations. The latest market trend highlights a return of the term premium as the market driver. An array of factors, including economic conditions and inflation uncertainty, impacts term premiums. The implications for investors favor the short end of the Treasury curve and potential gains in steepening trades.
After the latest Federal Open Market Committee (FOMC) meeting on September 20, 2023, the 10-year Treasury yield saw a remarkable surge of 47 bps, reaching 4.82% as of October 4. This spike came after it closed at 4.36% the day before the FOMC meeting. Many market pundits attributed this sudden and substantial sell-off in the Treasury market to the hawkish stance adopted by Fed officials. This shift in rhetoric was further underscored by the removal of 50 bps of rate cuts for 2024 from the FOMC's Summary of Economic Projections compared to the June projections. Some claimed that the Federal Reserve was signaling a commitment to keeping the target Fed Fund rate "higher for longer."
To comprehend the factors driving the Treasury market's sell-off, it's essential to dissect the concept of the term premium. Long-term Treasury yields, as succinctly explained by the New York Fed, consists of two elements: expectations regarding the future path of short-term Treasury yields and the term premium. The term premium can be seen as the compensation investors demand for bearing the risk that interest rates may change during the bond's lifespan. Essentially, it serves as an insurance premium against the uncertainty of future yields compared to current expectations.
To better understand whether the sell-off in US Treasuries is predominantly due to a rise in short-term interest rates or an increase in term premiums, we can turn to historical data. The New York Fed has employed the Adrian, Crump, and Moench (ACM) model to estimate the term premium of Treasury securities with maturities ranging from 12 months to 10 years, dating back to 1961. Figure 1 depicts this historical data, with the blue line representing the 10-year Treasury note yield and the green line illustrating the estimated term premium using the ACM model.
A noticeable pattern emerges from this analysis. During specific periods, such as March 1967 to May 1970, March 1971 to September 1975, December 1976 to February 1980, June 1980 to September 1981, and June 2003 to June 2004, surges in yields were primarily driven by expectations of a higher interest rate path. In contrast, during other periods like August 1986 to October 1987, October 1998 to January 2000, December 2008 to June 2009, and July 2012 to December 2013, surges in yields were more influenced by substantial increases in term premiums.
Turning our attention to recent market dynamics, the current bond bear market, which commenced in August 2020, initially witnessed the 10-year Treasury yield rising due to an increase in the term premium. However, from September 2021 onwards, the surge in yields was primarily driven by a significant upward adjustment in expectations of interest rate hikes. During this period, the term premium remained relatively subdued, fluctuating within a range between zero and minus 100 bps (Figure 2).
Notably, a shift occurred in July of the current year. The 10-year Treasury note experienced a 95 bp increase in yield, climbing to 4.68% on October 2, 2023, from 3.75% on July 19, 2023. This surge was entirely attributed to a substantial 117 bp increase in the term premium over the same period (as illustrated in Figure 3). Similarly, following the September FOMC meeting, the 10-year yield rose by 27 bps to 4.68% as of Oct 2 from 4.41%, with the term premium increasing by 55 bps, transitioning from -33 bps to +22 bps. Contrary to media headlines and pundit commentaries suggesting expectations of a "higher for longer" interest rate path, the ACM model's estimate indicates a decrease in interest rate expectations over the life of the 10-year Treasury notes since the September FOMC meeting.
Adrian, Crump, and Moench's study suggests that term premiums tend to rise during specific economic conditions. These conditions include periods when the economy is entering a downturn, when professional forecasters disagree on future bond yields, and when investors become increasingly uncertain about future Treasury yields. Currently, these conditions seem to be in place.
Additionally, one can conjecture that the increase in uncertainty about the future trajectory of inflation, the Federal Reserve's tolerance for deviations of inflation from the 2% target, speculation about the Fed potentially resetting the inflation target, questions about the long-term level of the Fed's neutral rate, uncertainty surrounding the demand for upcoming large Treasury issuance, a rise in the risks of a liquidity event in the Treasury market, and concerns about of rising fiscal dominance are all contributing factors.
Over the past six decades, the term premium for the 10-year Treasury note has typically been positive, with only a brief departure from this pattern occurring since 2015. This period of negativity in term premiums was an anomaly. The mean average term premium over this historical period was +151 bps, while the median stood at +154 bps.
Though the term premium has recently returned to positive territory, registering at 22 bps as of October 2, 2023, it still falls below the mean and median levels observed over the past six decades. This suggests the potential for a mean reversion of the term premium to higher levels, especially given the various factors previously discussed.
In light of the aforementioned analysis, certain investment implications become apparent. We recommend focusing on the short end of the Treasury curve as opposed to the long end. This preference is grounded in the anticipation that the Fed will implement rate cuts in the first half of 2024, even amid what might seem like hawkish rhetoric. These rate cuts are expected to materialize as signs of a weakening US economy emerge. Furthermore, the Fed's efforts to prevent a liquidity event in the Treasury market may lead to reductions in policy rates.
Additionally, the Fed may consider discontinuing interest payments of 5.4% on reserve balances and terminating fixed rate Temporary Open Market Operations that offer 5.3% on overnight reverse repos. This could result in annual savings of USD250 billion for the Fed and incentivize banks to withdraw a substantial portion of their USD3.2 trillion deposits at the Fed to invest in Treasury securities, including T-bills, which are close substitutes for interest-bearing reserves. Money market funds may also transition their USD1.4 trillion reverse repos into purchasing T-bills. This collective action could generate significant demand, amounting to USD4 trillion, for short-term Treasury securities. These factors collectively suggest a potential for lower yields and higher prices for short-term Treasury securities.
For traders looking to capitalize on these dynamics, a steepening trade strategy could be considered. This involves shorting the 10-year T-note futures while simultaneously going long on the 2-year T-note futures. This strategy leverages the anticipated yield curve dynamics resulting from the factors discussed. Readers interested in pursuing this strategy can find more information on how to calculate the duration-neutral number of contracts for each leg of the trade here.
In conclusion, the recent surge in bond yields is not simply a consequence of the Fed signaling a "higher for longer" interest rate stance. It is, in fact, a complex interplay of factors, including expectations of interest rate hikes and term premiums. Understanding these dynamics and their historical context is crucial for making informed investment decisions in the Treasury market. As we navigate these uncertain financial waters, being mindful of the term premium and its potential for mean reversion provides valuable insight into the future trajectory of bond yields and their implications for investors and traders alike.
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