There’s a Big Change Underway in Bond Markets

Of course, there’s never much agreement when it comes to the term premium, from what it might mean for the rest of the market to where it ‘should’ be. In many ways, it’s the Rorschach test of the financial world. You can see anything you like in it, and use it to justify (or dismiss) almost anything that’s happening. For instance, when the yield curve inverted back in 2019 in a traditional harbinger of economic recession, people blamed it on low term premia.

Now talk is heating up as concerns over inflation and discussions of future tapering by central banks have combined to spark that bounce in U.S. Treasury yields. Citigroup strategist Matt King kicked off the conversation back in March, arguing that this year’s jump in yields was more about changes in term premia than investors expecting higher interest rates from the Federal Reserve as the U.S. economy recovered from a historic pandemic.

It makes some sense that term premia would rise given that so much of market uncertainty is concentrated at the long-end of U.S. government debt. The Federal Reserve has repeatedly pledged to look through a ‘transitory’ pick-up in inflation and keep rates low, at least in the near-term. And with the U.S. having crossed the Rubicon of fiscal stimulus, there’s plenty of uncertainty about the longer-term impact of a wave of additional debt. As King put it: “One might almost speculate more strongly still: until the bond vigilantes reawaken, politicians have every incentive to continue handing out free money to their citizens. What could be more natural, then, than the return of a few basis points of risk premium?”

Over at Barclays, analysts led by Anshul Pradhan have echoed the sentiment, arguing that the metric remains far too low given the amount of uncertainty now faced by investors. “What that means for markets is that even if the modal expected policy outlook is unchanged, investors should demand a higher than usual term premium for taking duration risk at least until the dust clears and uncertainty subsides,” they wrote this month.

TD Ameritrade analysts led by Priya Misra echoed the sentiment this week, noting that an unwind of central banks’ bond-buying programs will leave government bonds more vulnerable as more of them will need to be snapped up by private investors. She estimates that almost 53% of the net issuance of U.S. sovereign bonds in 2020 was purchased by sovereign banks, with that figure expected to drop to 48% and 44% in 2021 and 2022, respectively. “The pickup in duration supply over time is one of the reasons for our forecast for higher term premiums and higher yields later this year,” she notes.

And then there are those who argue that there may be more unexpected demand for U.S. debt waiting in the wings — perhaps even enough to compress the term premium rather then send it shooting up. Zoltan Pozsar, Credit Suisse’s money market guru and a frequent Odd Lots guest, suggests tapering in the U.S. could be timed with another big event: Just as the Fed retreats from the market, another very large buyer could step in.

As Pozsar put it in research published on Tuesday:

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