The U.S. Treasury yield curve is as flat as it has been since the financial crisis of 2008-09. When asked for the likely cause, most students of the yield curve would ascribe it to a low “term premium”—the compensation that fixed income investors receive to compensate for the uncertainty around future central bank policy, inflation shocks or growth shocks.
In this paper we look past the academic controversies between different econometric models of the term premium to observe that they all agree on one important thing: the premium has been falling steadily since 2009 and is currently at or below zero. In our view, investors are therefore not only undercompensated for long-horizon risks, but also exposed should the term premium revert to its historical mean. Given our view that such mean reversion is likely in the long term, we believe those investors who are not holding government bonds to hedge long-dated liabilities should consider tactically rotating into shorter-dated bonds.
Executive Summary
- As government bond yield curves have flattened over recent months, attention has turned once again to the concept of the “term premium”: the excess return that market participants require for holding longer-dated bonds as opposed to rolling shorter-dated bonds.
- Determining the level of the term premium is challenging and controversial, and many different models have been developed by academic and finance-sector economists and econometricians over the years; however, most models show that the term premium has been falling steadily since 2009 and is currently at or below zero regardless of which market we look at.
- We argue that this is due to the four reasons:
- A lack of recent growth or inflation shocks
- Lower macro volatility accompanying a downward shift in the level of U.S. nominal GDP trend growth
- Technological advancements resulting in lower and less volatile inflation
- The adoption of forward guidance, quantitative easing and zero interest rate policy by major central banks
- We set out three reasons why we believe the term premium will increase over the longer term, and we believe that means investors who are not holding government bonds to hedge long-dated liabilities should consider tactically rotating into shorter-dated bonds.
The Term Premium is Correlated with Macro Uncertainty
Source: Bloomberg, Federal Reserve.
ACMTP10 = U.S. 10-year Treasury term premia estimates by New York Fed economists Tobias Adrian, Richard Crump and Emanuel Moench (see Adrian, Crump and Moench, 2013).
