Column-October Takes a Turn for the Worse: Mike Dolan

By Mike Dolan

LONDON – If the persistent ‘term premium’ in bond markets is diminishing again, then last month’s bond sell-off might just have been an unsettling episode. However, it may require close attention to both Treasury developments and Congress alongside the Federal Reserve to ensure that this situation does not recur.

Following a sharp increase in long-term U.S. borrowing rates in October, Treasury yields experienced a significant reversal, dropping by more than half a percentage point late last week. This drop followed indications of a cooling labor market, along with a revised and more manageable government borrowing schedule for 2024.

Federal Reserve governor Christopher Waller described the yield shock as akin to an ‘earthquake.’ The velocity of the reversal was remarkable; nearly all of October’s 50 basis point spike in 10-year yields has vanished, and almost half of the increase observed since midyear is also gone.

Rising yields have consistently attracted investors, who seem to have accumulated bonds throughout the year to take advantage of the highest fixed-rate coupons seen in over a decade. Their belief that Treasury yields would peak around 5% has been supported by data indicating a slowdown in job growth and correlated expectations of the Fed potentially reducing rates by mid-2024.

Even if real, long-term neutral rates have risen to about 2% and the Fed strives to bring average inflation back to 2% — as indicated by former U.S. Treasury Secretary Larry Summers — there still seems to be potential in 10-year Treasury yields currently at around 4.5%, particularly for investors willing to endure some temporary fluctuations.

However, the noteworthy element of the October sell-off was the reappearance of a previously scarce buy-and-hold premium, commonly referred to as a ‘term premium.’ This premium is an additional yield that bond investors demand to hold long-term bonds to maturity rather than opting for short-term securities.

While it is somewhat elusive, the term premium reflects uncertainties regarding potential adverse developments over the lifespan of a decade-long bond—beyond existing assumptions about interest rates and inflation trends. It often points to concerns over the supply of debt. In this case, it seems to have been influenced by multi-year U.S. deficit projections, stalemates in Congress, and the gradual reduction of the Fed’s involvement as it diminishes a pandemic-inflated balance sheet through quantitative tightening.

The New York Fed’s preferred model for estimating the term premium had remained mostly below zero for a decade, thanks in part to ongoing quantitative easing. Nevertheless, it surged dramatically over the past month. Climbing nearly 1.5 percentage points from midyear to an eight-year high of about 0.50 last month, the premium suggests market struggles to adequately price an influx of U.S. government debt sales alongside the Fed’s ‘higher for longer’ strategy and ongoing quantitative tightening.

This premium has also sharply collapsed during last week’s reversal, with the New York Fed’s estimate plummeting from October’s peak to just 20 basis points.

The relevance of this evolving premium is uncertain—whether it holds substantial weight or simply rides the waves of market fluctuations.

What is clear is that Federal Reserve officials, from Chair Jerome Powell to others, are paying close attention to it. Chicago Fed President Austan Goolsbee emphasized that understanding the reasons behind the recent yield spike is crucial for assessing the effectiveness of the Fed’s policies. "If that’s coming from term premium and it’s tightening, then we have to take that into account," he stated.

Fed Governor Lisa Cook also asserted that the term premium was a key factor behind the yield spike, doubting that changes in Fed expectations played a significant role.

If the term premium were to return to historical averages, it might mean tighter financial conditions, allowing the Fed to adjust its stance accordingly. Conversely, if the premium were to vanish again, the Fed may have to persist with its policies to further curb inflation.

As Summers indicated, a term premium returning to 60-year averages would amount to approximately 150 basis points—a substantial 130 basis points above current levels.

To ascertain whether this outcome is likely, investors may need to keep a close eye on Treasury developments, Congressional actions, and the duration of the Fed’s quantitative tightening.

Central to this month’s concerns is the fear of a spiraling situation. Ongoing deficits, exacerbated by significant servicing costs, could compel a larger portion of short-term debt to be refinanced into long-term bonds, perpetuating higher interest bills and extending budget shortfalls.

This context partially explains why recent positive Treasury tax receipts and a reduced fourth-quarter debt projection, along with a more front-loaded quarterly refunding plan, influenced yield reversals just as much as the employment data did.

However, the approaching election year, ongoing Congressional gridlock, and the risk of another U.S. government shutdown do not foster great fiscal optimism.

Morgan Stanley projects an impending surge of nearly $1 trillion in gross debt sales from G7 governments next year. After accounting for redemptions, this amounts to approximately $663 billion—a 34% increase compared to this year, with U.S. debt sales representing the largest share.

Yet, the firm believes a 32% rise in new debt sales, net of redemptions and central bank purchases, to a 14-year high total of $2.45 trillion could be comfortably managed in a weak economic environment characterized by declining rates and inflation. This marks only the fourth largest annual increase in the last 15 years.

Will the elusive ‘term premium’ return as a lingering concern, or are there optimistic prospects ahead?