Wall Street’s Latest Obsession Is an Unknowable Number
Signs that ‘term premium’ is driving up Treasury yields stir worry and doubt
Investors and Federal Reserve officials scrambling to make sense of surging U.S. Treasury yields have a new obsession: a number that exists only in theory.
Known as the term premium, the number is typically defined as the component of Treasury yields that reflects everything other than investors’ baseline expectations for short-term interest rates set by the Federal Reserve. That could include anything from an increase in the supply of bonds to harder-to-pin down variables such as uncertainty about the long-term inflation outlook.
In recent weeks, debate around the term premium has intensified because some financial models have suggested that it has been rising sharply—driving much of a recent surge in longer-term Treasury yields that has carried the yield on the 10-year note above 4.8% for the first time since 2007.
Treasury yields help dictate interest rates on everything from mortgages to corporate debt, making their rise over the past two years a steady source of anxiety for investors. So far, those worries have proved mostly unfounded, as the economy has shown little signs of buckling under the higher borrowing costs.
Yet the recent evidence of rising term premiums has provided a new source for concern. For some, they suggest that yields are no longer rising because of a strong economy and expectations for higher rates. Instead, the underlying cause could be something harder for the Fed to control and therefore more dangerous.
Still, even economists who created term premium models stress that their outputs are imperfect estimates, making it difficult to gauge whether or not they are a warning. Here’s a look at the current debate.
What is term premium?
Most analysts agree that yields on U.S. government bonds are largely determined by the anticipated path of short-term interest rates.
The rationale: Investors will buy a series of one-month Treasury bills instead of a bond that matures years from now if they think that will produce a better return. If this pushes the longer-dated bond’s yield too high, buyers will emerge so that the yield settles around a consensus for what rates will average over the bond’s lifespan.
Still, other factors almost certainly also influence yields.
According to a traditional understanding of term premium, investors may demand extra yield to buy longer-term bonds due to the possibility that rates could end up higher than they expect right now.
Additionally, yields could be influenced by the supply of government bonds, with a flood of new bonds overwhelming demand and pushing yields higher. Or investors may accept a lower yield—or negative term premium—because they figure that bonds, unlike stocks, should rally if the economy runs into trouble.
Evidence of a surge
Measuring term premium is where things get tricky, because there is no perfect way of knowing what investors think rates will be in the future.
The simplest approach would be to compare Treasury yields to rate forecasts found in surveys. But drawbacks including the infrequency of those surveys mean that the most popular models incorporate other methods.
Among those is the so-called ACM mode, named after the current and former New York Fed economists Tobias Adrian, Richard Crump and Emanuel Moench. It uses yields of different Treasurys to predict future short-term rates by effectively finding patterns in their relationships over decades.
Another model, devised by current Fed economist Don Kim and former Fed economist Jonathan Wright, is a hybrid, arriving at its rate estimate through a combination of both survey forecasts and yield data.
Outputs from both models have long provided fodder for debate, especially in the 2010s when they showed term premiums turning deeply negative. That had puzzled many who had become accustomed to models showing healthy-size premiums—substantially larger than they stand even now.
More recently, though, the models have gained attention because they have shown term premiums surging, with the 10-year premium climbing back into positive territory.
What Wall Street thinks is going on
Dallas Fed President Lorie Logan recently suggested that signals from term premium models made her less inclined to raise rates again this year, arguing that rising term premiums, if real, would mean that surging yields aren’t just reflecting stronger growth and a need for tighter monetary policies.
Logan didn’t delve deeply into what specifically is driving up term premiums. But on Wall Street, many have used term premium models to buttress arguments that yields have been rising largely thanks to a growing federal budget deficit.
In recent months, the Treasury Department has both increased its borrowing forecasts and boosted the size of its longer-term debt auctions by more than investors had been expecting.
The anecdotal evidence that yields are climbing due to shifting supply-demand dynamics is compelling, but the models showing rising term premiums are “the measure—that’s where you’re seeing it,” said Blake Gwinn, head of U.S. rates strategy at RBC Capital Markets.
Maybe it’s still about interest rates
Still, some caution that the term premium models should be treated skeptically. One issue: their reliance on historical patterns that might not apply now.
A feature of the ACM model, for example, is that its estimate of what short-term rates will average over the next 10 years has been much more closely linked to changes in the 2-year Treasury yield than the 10-year Treasury yield.
As a result, when inflation surged in 2021 and the 10-year yield rose much more than the 2-year yield, the model showed essentially no change in interest-rate expectations over the next decade—and therefore a big increase in the term premium.
The same was true in recent weeks, in contrast to last year when the rate forecast jumped along with the 2-year yield.
Term premium models have value but their outputs are “based on past experience,” said Wright, the co-creator of the Kim-Wright model who is now a professor at Johns Hopkins University. “It could be that this time is totally different.”
Some analysts argue that shifting rate expectations are still largely responsible for driving up longer-term yields recently. A resilient economy, they say, is persuading investors that rates—while likely to fall from here—are destined to settle at a higher level than previously anticipated.
Praveen Korapaty, chief interest rates strategist at Goldman Sachs, said he likes to look at term premium models but only along with other types of models that link changes in yields to factors such as economic data and Fed policy surprises.
Those, he said, generally support the idea that yields have climbed because investors are giving “more credence to the Fed’s ‘higher for longer’ message.”