A look at term premia

Why are bond yields so low?   On the face of it, that's an easy question to answer.  While you may not agree with the market pricing, you can nevertheless point to low inflation, massive central bank purchases of global bonds, the advent of negative rates, weak global growth, etc. as a reason why yields are so low.

But how satisfying is that answer?  Does the 1.71% that one currently receives from lending to the US government accurately reflect the market's belief in the likely trajectory of short term interest rates over the next decade?   Does the 0.10% that one gets from owning Bunds?  Yes, it's true that short rates in the US, Europe, and elsewhere are currently very low at the moment, and the precedent of Japan suggests the possibility that they could stay that way ad infinitum.  Yet short rate futures strips, particularly in the US, do price an eventuality of higher rates, and the FOMC dot plot (ha ha ha) also suggests likewise.  Surely the risk is of a more abrupt return to normalcy for the yield curve?

This is one of the reasons that academics and bond market analysts like to think of a term premium, the added yield beyond short rate expectations that investors require to own a bond for a duration beyond the immediate future.  The term premium essentially reflects the risk that your embedded short rate forecast is incorrect and the compensation that you require for that risk.

There are a number of econometric models of the term premium, some of which yield markedly different results.  A few years ago some New York Fed economists published their own model (known as ACM after the authors), which is an "affine class of term structure model which characterize yields as linear functions of a set of pricing factors."  While Macro Man isn't really competent to judge the relative merits of this model versus some of the others, it does confer the signal benefit of being downloadable on the NY Fed website and on Bloomberg, which allows the masses to play with it to our heart's content.

What's interesting to observe is that term premia across the curve are currently negative; in other words, bond yields are actually lower than those that would directly reflect the market's expectations for the trajectory of short-term interest rates.  To an extent, that is a satisfying result, insofar as it likely reflects the biases of a number of a number of market observers who don't happen to own several hundred billion dollars' worth of bonds.


Why should the term premium be negative?   Look no further than the March FOMC (and indeed much of the last 18 months); if you think that there's a risk that the Fed will continue to jelly on moving rates, it's natural that this should be reflected in the price.  Interstingly, if we look at the level of yields adjusted for this term premium (call it the "natural" level of yields), we can see them rise sharply across the curve with the announcement of the taper in December 2013.

Macro Man also had a look at the 2-10 term premium curve to get a sense of how it is impacting the nominal yield curve on an historical basis.    What do you know....the difference between the 2y and the 10y term premia is as small as it's ever been (reflecting a substantial flattening influence on the curve.)   The implication would appear to be that the balance of risk is heavily skewed towards a re-steepening, particularly given the volatility of the term premium curve.


Or is it?  If one were prepared to take the term premium as an independent explanatory variable, that forecast would resonate a lot.  However, given that these term premia estimates are generated by running regressions on the curve, Macro Man suspects that they are descriptive rather than prescriptive.   In other words, he reckons that bond yields don't rise and fall because of shifts in the level of the term premium, but rather the term premium rises and falls along with changes in bond yields and the shape of the curve.

Ask a CTA if he's piling into TY because he's adjusted his view on the term premium, and he's likely to respond "01001100 01001111 01001100".

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Bruce in Tennessee
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April 11, 2016 at 12:51 PM ×

http://wolfstreet.com/2016/04/11/blackrock-ceo-fink-negative-low-interest-rates-eat-into-consumer-spending-at-worst-possible-time/

...Yes, MM, low rates seem to be evaluated by more and more of us as an idea whose time has passed. I read today about new estimates of pension shortfalls, and decreased velocity of money, and other things I ascribe to low rates. It isn't that low rates had to be a bad idea, it is that low rates, having not produced the desired result after 8 years are a bad idea. I am not privy to the topics that will be discussed at the WH this week between Yellen and Obama, but I hope a new path will be charted.

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Anonymous
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April 11, 2016 at 12:57 PM ×

B in T

any links to pension shortfall ?

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washedup
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April 11, 2016 at 2:08 PM ×

"I am not privy to the topics that will be discussed at the WH this week between Yellen and Obama, but I hope a new path will be charted."

BinT - back from the ER - laughed so hard that I burst some capillaries and needed immediate medical attention.

MM - the negative term premium is just code for regulatory overburden because of collateral and Basel III requirements isn't it? I don't find too many smart people who expect inflation to stay low forever (given where commodities currently are), neither do they expect sovereign risk to decrease if that ever was a factor. but these folks all expect DM govt yields to stay low anyway because 'you see, institutions will be forced to hold them'.

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Bruce in Tennessee
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April 11, 2016 at 2:10 PM ×

http://www.theautomaticearth.com/2016/04/debt-rattle-april-11-2016/

US Faces ‘Disastrous’ $3.4 Trillion Pension Funding Hole (FT)

...Sorry, almost didn't come back...Monday and Thursdays are sports all day days...and you might suppose that pensions would be leery of equities here (and rightly so) so you do ponder how pension funds will fare in the next few years...

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Bruce in Tennessee
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April 11, 2016 at 2:13 PM ×

Washed...nothing like a good laugh to start the week!

Later.

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Booger
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April 11, 2016 at 2:30 PM ×

What about negative 10 year corporate bonds (nestle, Microsoft issues in Feb). If that is not a sign of a bubble, what is. One presumes that no one buying bonds here expects to actually hold to maturity.

And why not, because you have these CB's pony up to the poker table with a stack full of chips 1000 times bigger than anyone elses, so it is hard to bet against them.

I read somewhere, can't recall where, that stocks are like a friendly dog that CB's can pull in the direction required most of the time, bonds like a monkey that can be pulled in the right direction with a bit more effort and FX is more like a large ape. Controllable some of the time until it goes ape shit.

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Anonymous
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April 11, 2016 at 4:10 PM ×

Euro/USD getting ready for a Yen style move? Last time we spent material time above here (aside from August events) was Jan 2015.

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Polemic
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April 11, 2016 at 4:42 PM ×


2050 SPX.. yawwwwn - Someone going to sugest CBs have sold 2050 straddles in the next ' blame CBs for everything' conspiracy?

Comment-o-meter fallen off a cliff today. Has time and lack of resolution started to undermine conviction?

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Anonymous
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April 11, 2016 at 5:20 PM ×

What do you think that the Japanese CB meant by, 'it will intervene'?

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Anonymous
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April 11, 2016 at 5:30 PM ×

Germany's Avg Govt Bond Yield, known as Umlaufrendite, has dropped to ZERO for 1st time ever.

http://imgur.com/XDd6kXP

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Nico G
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April 11, 2016 at 9:19 PM ×

the tale of the yen (i had 105 'long term' target when i shorted USDJPY at 121) is much more important than oil or credit at this point.

it just shows the phenomenal fail of central bank cult lunatics i.e.. anyone who followed Kuroda/Abe don quixotesque, experimental financial seppuku - in 5 years time and later on, at universities, that 2009-2015 episode of central banks hypnosis will be studied by economics, finance and psychology students altogether

I am not sure who will crash first - Japan or Europe - but they will collapse for sure. Same social rigidité - the impossibility to reform and awful demographics all plagued by a strengthening currency against their will. Europe having a migrant/identity crisis as icing on the crab cake

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Bruce in Tennessee
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April 11, 2016 at 10:06 PM ×

http://www.marketwatch.com/story/alcoa-shares-slide-as-revenue-misses-wall-streets-estimate-2016-04-11?siteid=bigcharts&dist=bigcharts

Shares of Alcoa Inc. AA, -3.59% dropped in Monday's extended session after the aluminum producer posted revenue that fell short of expectations. Alcoa reported its first-quarter earnings shrank to $16 million from $195 million a year earlier. On a per-share basis, the company broke even versus a profit of 14 cents a share a year ago. Excluding items, Alcoa earned 7 cents a share, down from 28 cents a share in the same quarter last year. Revenue slid 15% to $4.9 billion. Analysts surveyed by FactSet had projected earnings of 2 cents a share and revenue of $5.2 billion. Alcoa is the first major U.S. company to report its quarterly results and marks the unofficial beginning of a new earnings season. Alcoa shares slid 3% in after-hours trading.

...There have been plenty of warnings about this earnings season....and the alpha is down on the mat...Juniper networks also looks less than robust...

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Mr. T
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April 11, 2016 at 11:22 PM ×

Funny for all the warnings about this earnings season the number of warnings from companies is awfully low. JNPR is the first biggish name I've heard of to warn, and at 10x EV/cashflow for a well managed company I'd be surprised to see declines there get out of hand.

I think it pains people to go through the contortions of comparing yields on equities to what they see as artificially low yields in other asset classes, but thats where we are now. When I can get 40bp more cash yield on SPY than on the US 10yr its hard to see the downside to stocks without first finding a reason for FI yields to be a lot higher. I doubt the catalyst for much higher yields, and thus a repricing in stocks, is going to come from a weak qtr or two in earnings.

I'm finding some pretty neat values out there now, with widely varying underlying ideas.

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