The Big Idea

Uncertain term premiums

| August 11, 2023

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Treasury yields need to cover inflation, the cost of money and provide some premium to cover a fair return to taking interest rate risk. At least that’s the traditional take. The Fed has broadly persuaded the market over the last two decades that the cost of inflation in the long run will be 2%. And a range of analysts try to estimate the real price of money, or r-star, which the New York Fed now puts at 1.14%. The recent rise in longer Treasury yields has revived discussion of rising term premiums, but that is a complex case.

A short history of term premiums

Analysts have traditionally measured Treasury term premiums as the yield left over after accounting for the expected path of short-term Treasury rates. Since at least the 1960s, estimated term premiums have typically come out positive. That makes sense. For investors operating in a world of risk and return, greater interest rate or duration risk should earn a higher return. The amount of that return may vary, just like the price of anything else, but it should be positive. Otherwise, why take risk? In the middle of the last decade, however, something changed.

Term premiums began to decline approaching the start of 2015 and have since run negative more often than not (Exhibit 1). The 10-year Treasury term premium from 2003 through 2014 bounced around a median of 132 bp. But from 2015 forward, it has bounced around a median of -42 bp. In other words, after calculating expected returns from rolling Treasury bills for 10 years, investors have bought 10-year Treasury notes at a median yield 42 bp lower.

Exhibit 1: Treasury term premiums have dropped since the start of bank LCR

Note: Data shows the Adrian, Crump and Moench (ACM) Treasury term premiums.
Source: Bloomberg, Santander US Capital Markets

The likely past impact of policy and regulation

Just as term premiums headed south, regulators in the US and worldwide began requiring banks to have more liquid balance sheets. From 2010 through 2014, US bank regulators developed the Liquidity Coverage Ratio, or LCR. LCR required banks to hold enough liquid assets—high quality liquid assets, or HQLA—for the bank to sell or finance the assets and meet demand for net cash outflows in a 30-day liquidity crisis. Although regulators published a schedule of HQLA that allowed a range of assets, US regulators clearly viewed bank reserves and Treasury debt as the best of the best.

Banks had to hold 60% of the required HQLA by the start of 2015 and 10% more each year until reaching 100% at the start of 2019. Phasing in the rules created a natural experiment in tighter liquidity requirements over time. LCR also came into play just as the Fed ended QE and stopped buying Treasury debt and MBS in October 2014.

Treasury term premiums broadly headed lower approaching and through the implementation phase of LCR. The drop in term premiums in 2014 may be due Fed buying, but the drop from 2015 forward arguably came from bank buying. And a drop in term premiums would make sense in a risk-and-return market if a material buyer appeared that valued assets for other reasons, such as the ability of the assets to meet policy or regulatory objectives.

Future influences on term premiums

Although bank regulators’ recent proposals made no changes to required liquidity, banks face higher capital charges and more consequences from taking interest rate risk, both of which create marginal incentives to invest in Treasury debt. Treasury debt has a lower capital charge, is easier to hedge with swaps, and the current SOFR curve allows a bank to swap a Treasury to lower duration and still get positive carry. The new proposed regulations adds to existing bank incentives to hold Treasury debt for its regulatory value.

Fed policy is also likely play a role in term premiums. History shows QE as a probable influence on past term premiums, too. Even though the Fed is letting its Treasury holdings fall, the Fed is likely a long-term holder of Treasury debt once QT ends.

That leaves term premiums partly in the hands of fiscal deficits and Treasury issuance, arguably some of the factors that have revived discussion of premiums lately.  The Congressional Budget Office has long forecast rising deficits and a higher balance of outstanding Treasury debt as a share of GDP. The latest Treasury refunding announcement may have just reminded investors of that.

Banks, the Fed and fiscal deficits should ultimately shape term premiums. For now, I’d put my money on steady demand for banks to stay liquid and for term premiums to run low.

* * *

The view in rates

OIS forward rates see no more hikes from the fed and roughly steady rates through March. The same forwards then anticipate 100 bp of cuts from March to December 2024. The market is probably missing one more hike in November. Other than the missing hike, the market at this point is pricing a fair path. The Fed may hold rates high into July and then cut 100 bp by December, but that amounts to a small difference in the long run. The risk to the market is that sticky inflation keeps the Fed at higher rates for even longer, which would eventually create credit problems for balance sheets funded at floating rates that already are burning cash.

Other key rate levels:

  • Fed RRP balances closed Friday at $1.77 trillion, down $20 billion from a week ago. Heavy Treasury issuance in the second half of the year should keep T-bill yields attractive, a potential draw for cash now parted at the RRP.
  • Setting on 3-month term SOFR traded Friday at 536 bp, roughly unchanged over the last week.
  • Further out the curve, the 2-year note closed Friday at 4.89%, up 13 bp in the last week. With the Fed likely to hike again and hold fed funds closer to 5.50% into next year, fair value on the 2-year note is above 5.00%. The 10-year note closed at 4.15%, up 12 bp in the last week. Much of the rise in 10-year yields came after hints of a shift in Japan’s yield curve control and the Treasury announcement of heavy supply ahead. With inflation likely to drift down and growth likely to slow, fundamental fair value on the 10-year note is closer to 3.50%.
  • The Treasury yield curve closed Friday afternoon with 2s10s at -74, roughly unchanged over the last week. Expect 2s10s to reflatten beyond -100 bp again as the Fed keeps short rates high and concerns about growth and recession grip long rates. The 5s30s closed Friday at -4 bp, flatter by 10 bp over the last week.
  • Breakeven 10-year inflation traded Friday at 237 bp, unchanged over the last week. The 10-year real rate finished the week at 178 bp, up by 12 bp in the last week.

The view in spreads

The Bloomberg investment grade cash corporate bond index OAS closed Friday at 146 bp, wider by 2 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 174 bp, wider by 5 bp in the last week. Par 30-year MBS TOAS closed Thursday at 71 bp, wider by 13 bp in the last week. Both nominal and option-adjusted spreads on MBS have been particularly volatile in the last month.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market funded with floating debt look vulnerable. Leveraged and middle market balance sheets are vulnerable, especially with the tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans in September should add to consumer credit pressure.

Steven Abrahams
1 (646) 776-7864

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