Yields Will Get Shock If Term Premium Comes Seriously Into Play

Authored by Simon White, Bloomberg macro strategist,

Term premium has only been a minority contributor to the rise in US and global yields so far.

However, headlines just out on Iran apparently rejecting a ceasefire are a reminder that yields are set for more upside as geoeconomic and inflationary impacts become further embedded.

There’s a calm-before-the-storm feeling as markets cautiously entertain the prospect of peace talks between Iran and the US.

Stocks are down around the world since the war started but the US, with its energy independence, has fared much better than European and most Asian countries, which are heavily dependent on imported oil and gas.

Yields are also higher globally as markets factor in inflation from the energy shock.

But the majority of the rise in the US, Japan and European countries has come from an increase to central bank rate expectations.

Term premium – the residual of the yield move that encapsulates all the other risks embedded in owning longer-term government bonds, such as inflation and volatility – has only played a bit part so far.

The UK has seen the largest rise in term premium of the countries in the above chart.

Yet even there, it along with France, the countries straying closest to the sun in fiscal overreach, term premium has likely only contributed 25% of the total move in 10-year gilt yields since the war began.

Term premium models are not freely available for most countries.

So in the above analysis I use the ACM model for term premium as a basis, and built a working model using the most liquid government bond maturities (2y, 5y, 10y and 30y).

A very good approximation for term premium (which matches up well with published models where available) is then a 2y5y10y fly with a short in the 30y.

Back to the chart above. The results are intuitive, with the UK, Italy and France seeing the largest rises in term premium since the war began, and Germany and the US with lowest.

But it also highlights a vulnerability.

If inflation expectations rise even with a higher policy rate outlook (as is happening), then term premium will soon increase more too (a view echoed by Skylar Montgomery Koning), not just among the energy exposed, fiscal miscreants such as the UK and France, but the US too.

If rate expectations stay elevated, then that means global yields have further to rise.