Evaporation of Term Premium Shows Treasuries Reign Supreme

Updated on
  • No extra compensation demanded for first time since election
  • Europe’s political risk helps stoke flight-to-quality demand

U.S. Treasury securities are proving once again that investors can’t resist the allure of the global benchmark for bonds in times of uncertainty.

Investors are no longer demanding extra compensation to own 10-year Treasuries instead of a series of shorter-maturity obligations, a spread known as the term premium. Buyers had begun to build in the cushion after the presidential election of Donald Trump boosted expectations his pro-growth agenda would spark inflation. The premium turned negative at the end of February, according to the most recent calculations from the Federal Reserve Bank of New York.

Demand for Treasuries has risen even as expectations for the Fed to raise interest rates next week become nearly unanimous. A rise of uncertainty in Europe related to the upcoming French elections and an absence of a definitive timetable for Trump’s fiscal and tax plans has helped to whittle down the premium demanded by investors to hold U.S. government debt.

“The safe-haven flows induced by the French elections is the dominate factor depressing term premium in the U.S.,” said Roberto Perli, a partner at Cornerstone Macro LLC in Washington and a former senior Fed economist. “Also, the market had priced in a lot of hope in terms of U.S. fiscal policy and the details have been slow in coming.”

The drop in European yields relative to U.S.’s 10-year “has widened yield spreads and caused more demand for Treasuries,” said Edward Acton, an interest-rate strategist Citigroup Inc. in New York. “Flows have started to return to the back-end of the U.S. debt.”

Investor concern that France’s nationalist candidate Marine Le Pen could gain support in the upcoming presidential election triggered buying in the safest of government debt from German bunds to Treasuries. Yet Treasuries have been more appealing than bunds as the prospect of more imminent Fed tightening boosted their relative yield.

The 10-year premium will fall 0.06 percentage points this month, and that combined with the path for the Fed’s policy rate projects the 10-year Treasury note yield to end this month at 2.33 percent, according to CornerstoneMacro’s model. The yield was 2.49 percent Tuesday.

As of Feb. 28, the most current reading, the New York Fed’s model of 10-year Treasury term premium was minus 0.0164 percentage point. That’s down from as high as positive 0.2663 percentage point after the election. It was negative from mid January 2016 until Nov. 10.

“Until we get some certainty in terms of French election, there is probably still going to be a compression of the term premium in the U.S.,” said Perli.

(Updates 10-year note yield in the seventh paragraph.)
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