Should We Fear the Rapid Rise of Interest Rates?

Term premiums have been on the rise, but should investors be concerned? Stephen Dover, Head of Franklin Templeton Institute, explains what term premiums are, and why they are worth paying attention to.

Originally published in Stephen Dover’s LinkedIn Newsletter Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Since July, bond yields have been on a tear. The US 10-year Treasury yield has jumped from 3.75% in the third week of July to a recent high of 4.81%.1 Rising government bond yields have pushed up new borrowing costs for companies and households. For instance, the conventional 30-year US fixed rate mortgage is about 7.3%, its highest level since 2000.2 Compared to its lows during the pandemic (closer to 4%) an American taking out a US$325,000 mortgage will today pay nearly US$10,000 more per year in interest.

Rising term premiums have driven the latest jump in bond yields. Rising term premiums represent the additional yield investors require to bear the risk of holding longer-dated notes and bonds relative to shorter-term ones, and they impose higher costs on all borrowers—households, businesses, and the government. Indeed, if the jump in term premiums is maintained, it could prove terminal for economic expansion, as well as for equity and credit markets.

Some basic bond stuff

Observed long-term interest rates (often referred to as nominal bond yields) can be decomposed into three components: 1) the path for the neutral real short-term rate of interest; 2) compensation for expected inflation; and 3) the term premium.

The neutral real rate of interest is the rate—adjusted for inflation—that neither stimulates nor hinders economic activity. It should prevail when the economy is in equilibrium, i.e., enjoying full employment and price stability.