Curmi & Partners

What happened to term premium?

By Matthias Busuttil

The US treasury market is displaying signs which are non-synonymous to what many would consider to be the current economic conditions and growth outlook in the US, including the Federal Reserve. The US treasury yield curve has been flattening since the end of 2016 as short-end yields moved higher while long-end yields trailed lower.

The flattening in the treasury yield curve is strange when the underlying economy is supposedly reaching full employment and the Federal Reserve (Fed) is in the process of tightening monetary conditions. Such periods are normally characterised by higher inflation expectations and, consequently, a steeper yield curve.

1. What happened to the US Treasury Yield Curve?

Starting from the historically low position of the treasury curve in 2016, the turnaround in market sentiment occurred following the US elections in November 2016. Market participants increased expectations of strong reflationary pressures as a result of the pro-growth policies announced by Donald Trump. This period coincided with communication by the Fed indicating a more determined approach in tightening monetary conditions.

The ensuing steepening in the yield curve can be observed in the embedded chart by comparing the treasury curve as it stood pre-US election results on 8th November 2016 and the peak of yield curve steepening on 22nd December 2016.

Since December, the Fed has delivered three rate increases of 0.25% each which explain the move higher in short-term yields. On the other hand, long-term yields actually retreated lower resulting in an overall flattening movement in the treasury curve up until the date of writing (2nd August 2017).

2. How?

The downward pressure on long-term treasury yields is attributed primarily to the increasing political uncertainty and growth outlook in the US. Additionally, certain economic data, mainly core inflation and wage growth, have not been particularly strong.

The second factor is the external macro environment. Geopolitical risks and the persisting monetary accommodative environment in other economic zones still weigh on treasury yields as investors view US treasuries as an attractive safe haven alternative.

Moreover, it is also important to mention that the Fed is still participating in the treasury market in order to reinvest the maturing proceeds of its quantitative easing holdings. This means that the Fed is still a sizeable buyer in the treasury market.

3. What does this mean for investors?

A flat yield curve means that investors are being compensated less for the additional risk of holding a longer-term bond as opposed to a series of short-term bonds. Investors would normally require a higher rate of return for long-term lending given the uncertainty of future borrowing costs. This additional return is known as the "term premium".

According to Fed estimates, the current term premium for holding a 10-year US treasury note is actually -20 basis points. This estimation implies that short-term rates are expected to increase such that the return earned on the short-term investments exceeds the current long-term yield.

However, current market pricing is suggesting otherwise. The current level of long-end yields indicates market expectations that short-term rates and inflation in the future are not expected to be as high, suggesting a period of economic slowdown or possibly a downturn further down the line.

4. How can the "term premium" be restored?

A potential catalyst for the term premium to be restored and the yield curve to re-steepen firstly lies with the US government. The strengthening of market confidence in their administration and ability to implement their proposals would renew growth prospects, improve the much-desired wage growth figures and provide a solid base for reflationary expectations.

Another potential catalyst will be the next move of the Fed. Expectations are mounting for the Fed to announce a reduction in the reinvestment activity of maturing treasury holdings in September. Depending on the scale of the reduction, the Fed could impact the term premium as the US treasury may face increasing interest costs to attract new buyers. To this end, the issuance plans of the treasury will also play an important role.

5. If not...

A persistently low or negative term premium indicates that economic conditions are not self-sustainable and central bank involvement is still required. In the current environment, such a scenario would reveal that the Fed acted too soon in normalising monetary conditions. One would expect to see a reversal in policy, possibly involving rate cuts and a deceleration or halt of the unwinding of the Fed’s balance sheet.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.