Posted by Lawrence Gillum, CFA, Chief Fixed Income Strategist
Tuesday, October 24, 2023
The move higher in Treasury yields (lower in price) has been unrelenting, with intermediate and longer term Treasury yields bearing the brunt of the selloff recently. Since the end of July, 10-year yields are up over 0.90% and 30-year yields up 1.0%. While most of the move can be explained by the changing expectations of Federal Reserve (Fed) rate hikes, an increase in the Treasury term premium has pushed yields higher as well.
Economic theory suggests that each security on the Treasury yield curve can be thought of as the expected fed funds rate over the maturity of the security, plus or minus a term premium. The Treasury term premium is the additional compensation required by investors for owning longer maturity Treasury securities. The term premium, which is unobservable and thus has to be estimated, takes into consideration things like Treasury supply/demand dynamics, foreign central bank expectations and the potential for higher inflation in the future, to name a few. And since the end of July, which is when the last Treasury quarterly refunding announcement (QRA) was made that surprised markets because of how much new debt would be coming to market, the term premium has increased dramatically. The next QRA is October 30, so if the Treasury department surprises markets again with the amount of debt coming to market, we could continue to see the term premium move higher.
The term premium had largely been negative (since 2016) until recently. That time period coincided with steadily falling inflation as well as central banks that were actively owning large amounts of Treasury bonds. If those two conditions are fading, along with a supply/demand picture that remains tenuous, then the bond term premium may indeed be headed higher. How high? Getting back to normal would imply around a 1% term premium or nearly double from current levels, which could continue to pressure yields higher.
So what does this mean for fixed income investors? A positive term premium will likely keep longer term interest rates elevated and could reduce the diversification benefits of core bonds. Regarding the former, while monetary policy expectations are still going to be the primary driver of changes in interest rates, as the Fed starts to cut rates, longer term interest rates likely won’t fall as much as they otherwise would have absent a positive term premium. And as for the latter, while we still think Treasury securities will be the safe haven choice in the event of a broad macro equity market sell-off, they may not be the defensive choice for garden variety equity market selloffs. With cash rates at levels last seen in 2007, cash and cash plus alternatives could be good defensive options for portfolios. But, with yields on most fixed income asset classes at levels last seen over a decade ago, the longer term return potential for fixed income is the best it’s been in quite some time as well. Starting yields are the best predictor of future returns (over longer time horizons) so if Treasury yields remain elevated that of course means yields for other bond asset classes will be higher as well which means fixed income returns will likely be higher too.
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