It’s the buzz word on Wall Street and in the hallways of the Federal Reserve and Treasury Department. It’s blamed for triggering bond selloffs, shifts in debt auctions and interest-rate policy. That few agree on what exactly it reflects, or how to measure it, seems to matter little—the term premium is a powerful new force in the market.
Typically described as the extra yield investors demand to own longer-term debt instead of rolling over shorter-term securities as they mature, the term premium, in the broadest sense, is seen as protection against unforeseen risks such as inflation and supply-demand shocks, encapsulating everything other than expectations for the path of near-term interest rates.
The problem is it’s not directly observable. Various Wall Street and central bank economists have developed models to estimate it, often with wildly conflicting results. The one thing that most market observers, including Federal Reserve Chair Jerome Powell, can agree on is that in recent months the term premium has soared, likely fueling the dramatic ascent in long-term rates that only recently has started to fade.
The implications for the trajectory of monetary policy are substantial. Powell and other Fed officials have said that the jump in the term premium could hasten the end of their interest-rate hikes by squeezing growth in the economy, effectively doing some of the work for them as they try to rein in inflation. Yet with traders having long struggled to handicap the Fed’s next moves, some warn the central bank’s focus on the notoriously hard-to-understand feature of the U.S. government debt market is making it even more difficult to anticipate the path of rates going forward.
“It seems like a strange door for the Fed to open,” said Jason Williams, a global market strategist at Citigroup Inc. “It’s puzzling as the term premium is something that by definition you can’t know, which the Fed realizes but still is saying its rise is important and can offset some potential hikes.”
The term premium is also factoring into fiscal policy. Last week the Treasury Department increased planned sales of longer-term debt by less than most expected. The decision, against a backdrop of swelling U.S. deficits, came after it was advised by an influential panel of bond-market participants to skew issuance toward maturities that are not as sensitive to term-premium increases.
For some, the U.S.’s surging debt supply is itself a likely element pushing the term premium higher.
“This is a very complicated question on what has been driving the long end of the yield curve,” Minneapolis Fed President Neel Kashkari said Tuesday in an interview with Bloomberg Television. “Some people point to term premium, and I always joke that term premium is the economists’ version of dark matter—it’s the residual of all the stuff we can’t explain.”
Kashkari said that if it’s indeed the rising term premium that’s behind the increase in yields, then “it is doing some work for the Fed” by tightening financial conditions. But if other factors are driving the move, such as an increase in the so-called neutral fed funds rate above which monetary policy is restrictive, or forward guidance on the path of policy, then the central bank may have to follow through with further rate hikes to keep borrowing costs elevated.
The term premium, as its name implies, has historically been a positive number, with the New York Fed’s widely-followed 10-year ACM model—named after creators Tobias Adrian, Richard Crump and Emanuel Moench—averaging about 1.5 percentage points since the early 1960s, as far as the data goes back. More recently, however, it’s been decidedly negative, touching a record low -1.66 percentage points in March 2020.
