WisdomTree: Hedge Your Bets! Term Premium in U.S. Fixed Income Markets May Be Poised to Rise

August 19th at 11:00am by Rick Harper -- WisdomTree

With stronger-than-forecast economic data and continued improvement in U.S. employment numbers, we believe that now may be the time to hedge U.S. interest rate risk. While rates in the U.S. have generally fallen so far in 2014, we believe that the market’s reaction to the most recent round of economic data suggests that anxiety about rising rates may be bubbling up again. A quick look at expectations embedded in the bond market suggests that investors may be vulnerable to a sharp move higher in rates. This concern is highlighted by the limited amount of income that investors currently require to invest in longer- maturity securities (relative to rolling shorter maturities over the same horizon). In economic circles and the Federal Reserve (Fed), this measure is commonly referred to as the term premium. In the current environment, we believe that the market may be underpricing the risk of higher rates. Recently, noted Fed hawk Jeffrey Lacker sounded the alarm that rates may rise faster than the market currently anticipates.1 As a result, we attempt to explain this rationale below.

Term Premium Explained

The term premium represents the incremental yield that investors require to hold a longer-term bond as opposed to a combination of shorter maturity bonds. There are many different ways to estimate the term premium, but a key factor is the anticipated evolution of short-term interest rates. Different models use market expectations embedded in futures, consensus estimates from strategists, or most recently, the Fed’s forward rate guidance to project how short-term rates will evolve over time.

In the chart below, we show the model employed by New York Fed economists. Their model derives the future path of short rates from current pricing of short-rate futures contracts. As we show in the chart, investors currently demand very little income for assuming interest rate risk. At 51 basis points (bps), the term premium is significantly below its five-year average and represents levels not seen since May 2013. In our view, investors should be demanding greater potential returns for bearing interest rate risk, given the changes in the economy and resulting Fed policy.
Federal Reserve Term Premium Estimate, 12/31/2008- 7/31/2014

Stronger Economic Data + Complacency = Higher Rates

During the last week of July 2014, market participants saw a barrage of economic data that seemed to corroborate the same message: the U.S. economy is continuing to grow, and the labor force is continuing to recover. Given that the Fed has focused on both of these factors as preconditions for eventually raising short-term interest rates, the Treasury market took notice. In the week after the better-than-expected economic data was released, U.S. two-year bond yields broke through 0.51%, the recent high that was set in September 2013 when the market was convinced that then-Fed Chairman Ben Bernanke would start “tapering” the Fed’s bond-buying program.

While the spike and eventual retracement in two-year yields may point to concerns about future tightening, longer maturities seem to paint a different picture. U.S. 10 Year and 30-Year Treasury yields are a full 44 and 57 basis points lower, respectively, than they were in September 2013.2 In this scenario, the yield curve has flattened, narrowing the spread between these maturities and the two-year. This is consistent with investors being rewarded less for assuming additional interest rate risk. Put another way, we believe that the prospect of higher rates has increased, but the cost of hedging this risk has decreased.

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