The spreading global bond rout is spurring a Wall Street debate on whether investors will demand to be paid for lending to the American government like they used to.
Even with inflation at the highest in decades, traders are still getting zero compensation for buying longer-dated bonds relative to rolling over shorter-term securities, a distortion known as a negative term premium.
Now hawkish central bankers from the U.S. to Europe could change all that. Their policy-tightening moves could cause investors to demand more rewards to hold everything from long-dated Treasuries and highly valued stocks to leveraged credit.
The theory: The Federal Reserve is poised to start unwinding asset holdings in the next few months just as monetary peers tighten in kind, potentially bringing more bond supply into the open market for the first time in years. And if inflation stay high -- against debt-market expectations -- it could compel money managers to price in much bigger premiums to cushion risks at the long-end of the curve.
“The term premium has been negative for a long time and we need to get back to a natural structure,” said Jason Pride, chief investment officer for private wealth at The Glenmede Trust Co. “Investors need to know that if you lend for longer periods off time, they will be compensated.”
The stakes are high, with a cohort of traders warning the liquidity-fueling status quo is dangerous.
“Failure to push long term rates higher will only mean the Fed is complicit in encouraging the misallocation of capital in the U.S. and global economies,” said David Kelly, chief global strategist at JPMorgan Asset Management, in an interview. “A higher risk premium is important for long-term financial stability.”
Thanks to the quantitative-easing campaign extended in the wake of the global financial crisis, the 10-year term premium has staged a volatile decline over the past decade in line with the broader bond bull market. It’s one of several elements that go to make up the yield curve, which measures the difference between what someone gets for investing their money for entirely different periods.
For much of the first half of 2021, the premium traded in positive territory as investors priced in the Biden administration’s massive stimulus package, before falling again on bets fiscal policy had peaked. Right now, the 10-year compensation is a negative 0.28 percentage point, according to the New York Fed “ACM” model by economists Tobias Adrian, Richard Crump, and Emanuel Moench. Since 1960, the average stands at a positive 1.55 percentage points. In other words, money managers are currently getting no extra yield to cushion risks, including price pressures and changes in the balance between supply and demand, over the coming decade.
How Fed policy tightening changes all this is the big question. Chair Jerome Powell last month said the central bank was ready to raise rates in March and to pare asset holdings later this year, a process known as quantitative tightening. When the Fed started reducing its balance sheet in 2017, it had already been raising rates for more than a year prior. That suggests QT is set to kick in faster and sharper this time round, given the prospect of successive rate hikes this year alone.
Bloomberg Intelligence forecasts the central bank will no longer reinvest existing holdings as they mature from May onwards, gradually amounting to $60 billion a month for Treasuries and $30 billion for mortgage securities.
Tobias Adrian, the “A” in the Fed’s ACM model, warns bond bears shouldn’t get too excited by this. If anything, Powell’s newfound hawkishness on rates could accidentally give bulls a shot in the arm, by reducing the premium investors demand for inflation risk -- something that’s now showing up in easing market-based measures of price growth ahead.
“While the Fed’s QT will raise term premium, on net, we still might be looking at a pretty negative level going forward,” said Adrian, who is now chief financial economist and director of the International Monetary Fund’s monetary and capital markets department. “The Fed will be lifting rates and Treasury’s financing needs have gone down, both of which pull term premium lower.”
Adrian estimates that the over $3 trillion in Treasuries the Fed has bought since the pandemic has lowered the 10-year term premium by about 50 to 60 basis points. Yet the Treasury is likely to make up for lost Fed funding in a benign way: By selling bills rather than longer-dated debt.
“It would be a different story if the Fed was selling assets and actually putting duration into the market -- that would be a true reverse QE operation. This runoff is not that,” said Praveen Korapaty, chief rates strategist at Goldman Sachs Group Inc. “So while we do think risk premia in the long-end should be higher, it’s not due to QT but because we think markets are underpricing the chance the Fed will have hike a lot more and that inflation will be stickier.”
Big Moves
The ever-flattening yield curve is making it harder for the term premium to normalize. Much therefore depends on the whether economic growth will break out in the years ahead -- and if there’ll be a synchronized global monetary tightening move that wakes up long-end yields.
With a big divergence between elevated inflation and the negative term premium, something may have to give. A low discount rate for the decade ahead pumps up cross-asset valuations, while increasing the urge among investors to venture into riskier markets for yield. At the same time, policy tightening to rein in market froth risks throttling the U.S. expansion.
“It’s a very tricky balance for the Fed,” said Rebecca Patterson, director of investment research at Bridgewater Associates. “They are trying not to tighten financial conditions to a point that it threatens the economy.”
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