Term Premium Showing Signs of Loss of Faith in Fed

An esoteric aspect of the bond market might be telling us something.

by Murray Gunn
Updated: February 03, 2022

The bond markets contain a wealth of information. As a rookie in the City of London, I was sent on the famous Salomon Brothers Bond Market Training Class, which they offered as a one-week immersion to their clients. It was full-on and getting my head round things like duration, convexity, callable bonds, mortgage-backed securities, and other such weird and wonderful stuff was a real eye-opener – as, of course, was going round the trading floor and meeting some of the larger-than-life characters written about in the masterpiece which is Liars Poker.

Another interesting part of the bond market is the so-called Term Premium. This calculates the rate of return that the market prices in for holding a long-term bond as opposed to holding short-term bonds and rolling them over to the same maturity. For instance, holding a 10-year bond as opposed to investing in a 1-year bond and then rolling it over nine times as it matures. The Term Premium in U.S. Treasury bonds can be thought of as the market's measure of how risky it is to tie capital up and lend to the U.S. government for a lengthy period, and that will be affected by attitudes towards things like consumer price inflation as well as the overall faith in the Federal Reserve.

The chart below shows an interesting feature whereby, from the mid-1960s to the early 1980s, the Term Premium was increasing. Consumer price inflation was rampant for much of the 70s and faith in the Fed was low until Paul Volcker decided to stamp his authority with his "Saturday Night Special" when he raised the Fed Funds rate by a full point (11% to 12%) on Saturday 6 October 1979 and followed up by raising it to a peak of 20% in 1981.

Since then, the Term Premium has declined relentlessly, even reaching into negative territory over the past few years, when the market thinks it is safer to hold long-dated bonds rather than short-dated bonds! Last year, though, the Term Premium jolted up before declining in what could be a three-wave movement. Is this an indication that the Term Premium is about to embark on a sustained uptrend once more?

We're certainly watching it closely because notice that, whereas a declining Term Premium has corresponded with a multi-decade bull market in stocks, a rising Term Premium was occurring as stocks were in a bear market. More than anything else, this metric will tell us if the markets are losing faith in the Fed.

(Editor: Our team of Financial Forecast Service analysts have just published complete analysis and forecasts for US stocks, bonds, gold, the dollar and more. Read it now.)