USE FOR TERM PREMIUMS
EDU DDA Oct. 24, 2024
Summary: Term premiums are now positive and rising. This means something very different to academics than the other side of term premiums. That opposite side is all fundamentals. The story of and behind term premiums and why academics turn to them so often exposes a lot more than they realize. It isn’t the risks they associate, rather a clear dishonesty and desire to obscure the most inconvenient set of truths in everything.
Term premiums have turned positive again, at least according to the Federal Reserve Bank of New York’s calculations. These are a big deal in academia, not so much anyone outside the cabal of Economists who fail to understand interest rates are fundamental. The truth is that term premiums are a reverse engineered attempt to get around the fundamental anchor of rates.
The US Treasury market, already mired in one of its worst losing stretches of the year, is flashing a fresh warning sign of mounting risks as yields surge.
The so-called term premium on 10-year Treasury notes — an expression of the extra yield investors demand for owning the debt rather than rolling over shorter-term securities — has risen from near zero to just under a quarter point so far this month to the highest since last November, a Federal Reserve gauge shows.
As academic as the indicator may sound, the measure is closely monitored by market watchers. It offers important information about investors’ perception of future risk — whether it be inflation, supply or anything else that extends beyond the expected path of short-term rates.
This is the reason why people have trouble understanding markets or even just interest rates. Much of the public has spent the past few years expecting deficits to matter rather than understanding and better absorbing the more critical reasons why they didn’t and won’t (sadly).
There are worse consequences than an unfettered, drunken sailor Uncle Sam and people would know what those are if they only viewed interest rates properly.
The story of term premiums helpfully illustrates why they don’t.
There is a fundamental value to the price of the Treasury. Thus, if the government sells more debt the marketplace places a high value on, the amount of supply is almost entirely immaterial. What Economists can’t fathom is why there would be such demand, most all when that demand appears to be in conflict with the “official” position.
In the middle 2000s, Ben Bernanke famously tried to make the demand side about a “global savings glut”, a demonstrably preposterous argument (though one that adequately enough explain his performance during the crisis which followed not long after he proposed this idea). In a nutshell, foreign governments were buying USTs for “unfathomable” reasons and using local savings at their disposal to do it.
He quite mistakenly missed several key factors, starting with many foreign governments’ experiences in the 1997-98 Asian not-financial crisis. This episode is properly classified as a regional (near global) dollar shortage. When the various Asian tigers, not to mention spilling over on Japan, ran out of dollar funding, they were, to put it mildly, royally screwed.
The lesson many around the area took away from the episode was that the eurodollar could be quite fickle and turn off the funding taps just as easily as they had been turned on over the preceding decades. This knowledge would have been useful for everyone around the world in the 2000s rather than savings glut garbage.
What that meant was in mistrusting the dollar system – therefore by proxy the Fed; so you can see why the Bernankes of the time didn’t want to go down this road – they began to pile up reserve assets quite understandably choosing safe and liquid US$ instruments: USTs and other GSE forms.
While that absolutely did help depress UST yields it wasn’t for undiscernible and unrelated reasons. This was a demand for safety and especially liquidity that just went unexplained by those around the Federal Reserve. In other words, those doing the buying perceived a higher degree of monetary risk in the eurodollar system than officials did, if only because there is no eurodollar system officially.
And they were right to do so, meaning the fundamental signal of lower interest rates in the middle 2000s was absolutely on the right track. Not long after Bernanke said savings glut, the need for safety and liquidity was on full display all over the world (not that it did foreign governments much good in the end, apart from those governments avoiding being wiped out themselves).
This was Alan Greenspan’s “conundrum” which really wasn’t one. Term premiums came up as an alternate way to explain it separate from the “savings glut.”
Greenspan’s Fed at the time was in the middle of raising ST benchmarks, back then the single fed funds target rate. He had anticipated all market yields would go up in lockstep with the Fed hikes (the “series of one-year forwards” theory). His conundrum was the “independence” being priced by longer-term rates from how he or Bernanke saw them.
This was nothing more than the yield curve flattening and then inverting which is pretty easy to explain, it just doesn’t reflect well on the Fed.
Bernanke sought to remove that implicit disagreement and market criticism (since market players were betting against the “central bank”) with his absurd savings glut. The term premium ruse was searching for the same goal from a very different perspective.
Economists instead looked at a flattening yield curve as better stated as a combination of risk components. In other words, investors demand additional return for lending money for a longer period of time, even to the UST. After all, there is at least time value to consider.
Like a lot of what Economists do, there is obvious truth behind the theory including the implicit requirement for an “ideal” yield curve to be upward sloping if for no other reason than time value. This is why, for instance, throughout the 2010s the OIS or eurodollar futures curves were upward sloping even though both markets priced little or no chance ST rates would move off zero.
But this assumes there is always an ideal curve, or Greenspan’s one-year forward series.
Applying this “logic” to the flattening curve situation, the term premium theory therefore recategorizes a flattening yield curve as a positive development: that investors are demanding less return for holding longer-dated instruments because they are optimistic about the future. By this view, Greenspan’s conundrum was actually flattering to him!
We were supposed to believe then, and still today, long-term UST investors just in front of the GnFC weren’t increasingly defensive over a meltdown whose chances rose with every misstep in the offshore eurodollar world, they were actually quite optimistic about economy or anything else and so term premiums were being lowered as a result.
Once again, we see how Economists and Economics completely turn around interest rates all in the stupid pursuit of making the Fed or any “central bank” look credible. They get it completely backwards and do it most often intentionally because this isn’t a scientific endeavor, it amounts to political zealotry cloaked in – to the layperson – impenetrable mathematics.
In the mid-2000s, the term premium was falling because the market disagreed with the path of ST rates. It really is no more complicated than that. As you can see, the trends for calculated term premiums are basically no different from the 3-month/10-year yield spread.
The flattening yield curve instead meant something entirely different, same as it always does and did. They basically invented unnecessary math all in order to change the meaning of what is straightforward but straightforwardly unflattering to the Fed.
Do you see why academics love term premiums while no one in the market takes them seriously?
In mechanical terms, the matter hinges on what the future path of ST rates “should” be. The term premium regressions believe it was or is whatever the Fed says, which is why the regressions rely most heavily on changes in the short end of the curve where interest rate policy is most influential. Realizing this, a falling even negative term premium in reality is just the market disagreeing with the ST path for interest rates, increasingly (lower premiums) and more emphatically (negative) rejecting the Fed.
Again, it’s just a different spin on flattening and inverting yield curves.
But that raises another matter, the one academic term premiums are now struggling with today. What happens when the market and the Fed eventually sync up?
That means what were low or even negative term premiums turn positive or become more positive. By their academic interpretation, this means the market is demanding more return to lend on a longer time basis, which means rising perceptions of risk. In the context of, say, 2006 and 2007 that seemed to fit the times.
But not quite, since the academic view interprets a wider term premium as higher risk, but as supply and demand not fundamentals. So, that would have to be something like too much Treasury supply or, as in the case of 2006-07, those foreign buyers suddenly not buying as many USTs as before. So, they looked at higher term premiums (or would have if they were widely used; they didn’t catch on until later) as very different risks, something like Treasury market participants more worried about a blowup in USTs.
Since this is backward, the real risk being perceived was just the opposite. Not a blowup in USTs, a blowup in money and economy that would lead to even more heightened demand for USTs (depression economics).
This is quickly seen as mimicked by the 3m10s spread. What was to the academics a rising term premium meaning was nothing more than the yield curve bull steepening. That’s it; that’s all it was. Same thing happened in 2001 leading into the dot-com recession (not to mention the “low term premiums” of the late nineties which was the same as the middle 2000s and for the same reasons).
There is a directional difference, though. Whereas risks associated with rising term premiums would look like the quote cited at the top of this DDA, a bull steepening yield curve is one where rates go down not up. Higher demand for safety and liquidity as an expression and a function of lower expectations for growth (and inflation).
This applies in both directions, too. Term premiums fell during the middle and later years of the 2010s, getting so low they turned negative for a prolonged stretch. That simply meant the yield curve flattened and eventually inverted, all because the Fed began raising rates which the marketplace didn’t agree with. Silent Depression vs. the “boom” and “recovery.” Again, you can see why term premiums are favored by who their proponents are.
Low term premiums would have meant low perceived risks, consistent with the idea of a “boom.” But they went too far and turned negative then stayed that way which simply exposed this for the nonsense it really is. Economists couldn’t come up with even a passable explanation for negative term premiums despite years of trying.
What really happened was nothing more than low growth and inflation expectations, Wicksellian depression economics colliding with the Fed’s intention to raise rates for a recovery the Fed said was going to break out which the market knew never was or would.
Fundamentals vs. the Fed.
And that brings us back to the rising term premiums of 2024, which, again, the other side of them is just the bull steepening yield curve. As term premiums are going up according to academic math, the 3m10s spread is really un-inverting. The former says rising risks over something like Treasury supply therefore rates are in danger of going higher and blowing up the Treasury market.
Bull steepening is far more concerned with the economy blowing up.
The one is with the Fed and how it sees a soft landing, the other is about the real economy and more. Under term premiums, rates would go higher. Bull steepening means rates go lower.
Negative term premiums all those years should have discredited the whole thing because there really is no way to make them make sense. They were always transparently dishonest to begin with, to apply “objective” math in the service of a subjective assumption that central bankers are all-powerful and more likely to be correct.
To arrive at that goal has meant completely upending the view of and from interest rates plus a lot more beside. That’s why we’ve heard for years there are “too many Treasuries” only to find out there never are. Depression fundamentals and economics (small “e”) trump Economics every single time.
