How important was the term premium in explaining the escalatory selloff in longer-dated US Treasurys since August?
That’s an important question, but it’s also a bit of a trick question.
The ACM model shows the 10-year term premium rose 100bps from August 1 to October 19. The rise in 10-year Treasury yields over the same period was — wait for it — about 100bps (93bps).
Plainly, there’s a connection. As Jerome Powell put it last week, commenting on the rise in Treasury yields, “it’s really happening in term premiums.”
And yet, as BNY Mellon’s John Velis wrote Tuesday, “It’s not axiomatic that a move in the term premium should result in a similar (in both magnitude and direction) yield move for 10-year notes.”
Indeed, if you look back a couple of decades, the linkage is on-again, off-again at best. The figure below, from Velis, simply plots the three-month rolling change for 10s and the ACM term premium.
Recently, the two series have moved up together, and it’s no secret why.
“The term premium has adjusted higher to reflect pops in supply,” Velis said. “In essence, the recent additional supply has been too big for the market to absorb at current prices, requiring higher term premia to clear the market.”
“Clear the market” is the key phrase there. The idea of a clearing price assumes the presence of buyers who are at least somewhat price conscious. If the bulk of supply is absorbed by price-agnostic buyers, then the market isn’t really in equilibrium. In the event the price insensitive bid wanes or disappears altogether, a real equilibrium will have to be established through price discovery. That’s what you’re seeing in Treasurys.
As Velis dryly remarked on Tuesday, “Lenders typically require an incentive to wait 10 years to get their investment back.” That incentive is the term premium. Ceteris paribus, it shouldn’t be negative.
The figure below shows… well, it shows exactly what it says it shows: Real money flows and 10-year yields.
The data excludes hedge funds and central banks.
“When yields rise, real money starts to buy,” Velis wrote. “Higher yields look increasingly attractive as entry points [but] such hopes have been dashed” as yields continued to go up, he went on, before not-so-gently noting that “these investors have been long and wrong on this trade.”
One concern is that if yields keep rising, long-only investors might eventually “capitulate for good,” as Velis put it. He thinks we may be perilously close to such a moment.
Read more: Treasury Market Struggles With Unfamiliar Dynamic In Buyers Who Care About Price
Is the real-money flow shown all into coupon/longer-duration, though? Or does the chart include flow into bills/short-duration?