The recent decline in a key measure has brought a sense of relief to bond markets, signaling a return to relative stability. This measure, known as the term premium, represents the additional yield that investors demand for holding long-term U.S. bonds, which carry more risk compared to shorter-term debt.
After more than two years of being in negative territory, the term premium unexpectedly turned positive on September 25. This generated considerable interest among Wall Street strategists and Federal Reserve officials. However, this peak was short-lived, as the term premium has since fallen back into negative territory for three consecutive days, following a period of hovering near zero.
Accompanying this shift is a decrease in the 10-year yield, which has dropped by 0.57 percentage points since its peak of 4.987% on October 19. This development is welcome news for bondholders, as it raises the prices of their existing bond holdings, resulting in higher total returns.
Take, for example, the iShares U.S. Treasury Bond exchange-traded fund (ticker: GOVT) and Vanguard Total Bond Market ETF (BND). These two ETFs experienced significant losses last year as bond yields rose. However, this week marks a turning point, with both ETFs now showing positive total returns.
So, what caused the term premium to evaporate? One factor is that the issues that initially drove the premium higher are now less worrisome. The announcement by the Treasury Department in August regarding a substantial increase in debt supply contributed to the initial rise in premiums. However, this month's announcement indicates a slower pace of debt increases, alleviating concerns.
Furthermore, economic data played a role in this reversal. October's inflation data showed a year-over-year gain of 3.2% in consumer prices, compared to 3.7% in September and a peak of 9.1% last year. The fear of higher inflation among bond investors diminishes as it erodes the real returns on bonds.
Labor Costs and Bond Market
A surprising decline in labor costs has brought hope to bond investors. According to November data, hourly compensation per unit of output fell by 0.8% in the third quarter compared to the previous year, contrary to the consensus expectation of a 0.7% rise.
The decrease in wages has a significant impact on inflation, with economist and founder of Rosenberg Research, David Rosenberg, stating that it has cooled off significantly. This cooling effect is distinctly disinflationary.
Furthermore, the unemployment rate rose to 3.9% in October, reaching its highest level since early 2022. This increase, along with signs of slack in the labor market, has given markets confidence that the Federal Reserve is unlikely to further stress the economy with interest-rate hikes. Rather, there might be discussions about rate cuts, as suggested by Rosenberg.
In response to these data points, investors have been buying longer-maturity bonds to secure current yields before a potential rate cut lowers them. A recent example is the 20-year Treasury auction this week, which saw investors accepting a slightly lower yield of 4.780% compared to the bidding deadline yield of 4.790%. This increased demand for Treasuries has contributed to lower yields or premiums.
However, there are still concerns amidst this positive news. According to high-yield bond expert Marty Fridson and Rayliant Global Advisors Research Head Phillip Wool, flights to longer-term securities typically occur when investors perceive a recession risk. They point out that the probability of an economic downturn is a reason for the lower term premium.
The retracement of yields also reflects a more fundamental concern: the growing worry that the notion of a "soft landing" was merely wishful thinking. The lagged impact of Federal Reserve policy is feared to ultimately lead the economy into a recession, as highlighted by Wool.