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Economic Insights

Keep an eye on the Treasury term premium, which is a gauge of the risk of holding longer-term bonds versus shorter-maturity securities. 

The real (that is, inflation-adjusted) yield on 10-year U.S. Treasury securities is very low by historical standards—it recently was 2.66% below its 22-year average before the 2008–09 financial crisis (see Chart 1). In theory, this could be due to a combination of secular and cyclical factors operating on both the demand and supply sides of the U.S. economy.

The low real bond yield has a major influence on asset values, because it raises the present value of future corporate earnings, coupon payments, rents, etc. If the real bond yield rose sharply without being accompanied by rising earnings expectations, it would force a broad re-pricing of equities and credit-sensitive risk assets, along with other assets that have fixed payment streams.

 

Chart 1. Inflation-Adjusted U.S. Treasury Yields Recently Were Near Multi-Decade Lows
Real U.S. 10-year Treasury yield (monthly), January 1, 1985–September 26, 2017

Source: U.S. Federal Reserve Bank of Cleveland, U.S. Federal Reserve Bank of New York, and Lord Abbett. Chart depicts inflation-adjusted yield on the 10-year U.S. Treasury note from January 1, 1985–September 26, 2017.
Past performance is not a reliable indicator or a guarantee of future results. The historical data shown in the chart are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.


A harmful, sharp rise in real bond yields could be triggered by a change in perceptions of inflation risk, increasing uncertainty about the path of future short-term rates, or a reassessment of the liquidity premium of safe assets. Any of these could trigger an increase in the Treasury term premium, which is the estimated risk embedded in a longer-maturity bond that is determined by the difference between the actual yield and the “risk neutral” yield (represented by rolling a series of shorter-term securities extending to the same maturity at current rate expectations). Basically, it’s a gauge of the level of risk inherent in holding a longer-term bond versus a series of shorter-term securities.

The current estimated term premium also is very low by historical standards; at a nominal value of -0.36%, it is 2.35% below the pre-crisis average. (See Chart 2.) As demonstrated during the “taper tantrum” in 2013, when the U.S. Federal Reserve miscommunicated its intentions regarding changes to its asset-purchase program, the term premium can change very suddenly, driving market yields sharply higher—the yield on the 10-year U.S. Treasury note rose by 1.66% in that episode—even in the absence of any changes in the longer-run secular forces keeping real bond yields depressed.

 

Chart 2. Term Premium on U.S. Treasuries Also Recently Held Near Historical Lows
Estimated 10-year U.S. Treasury bond term premium (monthly), January 1, 1985–September 26, 2017

Source: U.S. Federal Reserve Bank of Cleveland, U.S. Federal Reserve Bank of New York, and Lord Abbett. Chart depicts term premium on the 10-year U.S. Treasury note from January 1, 1985–September 26, 2017.
Past performance is not a reliable indicator or a guarantee of future results. The historical data shown in the chart are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Apart from the effects of unpredictable government decision making, a sudden re-pricing of the term premium is probably the biggest threat to current asset prices. History has taught us that this can happen in unexpected ways, even as key decision makers believe that they are acting rationally, and thus we should be very wary of increases in bond yields that appear unrelated to revisions to economic growth expectations.

 

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