Some commentators have expressed concern that Treasury yields might rise sharply once the Federal Open Market Committee (FOMC) begins to raise the federal funds rate (FFR), worrying, in particular, about a sudden increase in Treasury term premia. In this post, we analyze the dynamics of Treasury term premia over the last fifty years and discuss their evolution around recent tightening cycles, paying special attention to the 1994 episode when bond prices dropped sharply around the world. We find that term premia don’t typically rise when monetary policy tightens. We also conclude, based on the behavior of term premia and survey evidence, that the sharp rise in Treasury yields in 1994 was in large part due to an upward shift in the expected path of future short-term interest rates.
According to standard economic theory, the yield on a ten-year Treasury bond is composed of the expected path of short-term Treasury yields over the next ten years and the Treasury term premium. The term premium is the compensation demanded by investors for bearing interest rate risk, which is the risk that interest rates will change over the life of the bond. Since the term premium isn’t a directly observable variable, it must be estimated, most often from financial and macroeconomic variables. Here, we use a statistical model to describe the joint evolution of Treasury yields and term premia across time and maturities (see Adrian, Crump, and Moench [2012] for more details).Also at Liberty Street:
We start by plotting the estimated term premium along with observable variables to build some intuition about the economic underpinnings of the term premium. As a point of reference, the correlation between daily changes in our ten-year Treasury term premium and daily changes in the ten-year Treasury yield is about 70 percent. In the chart below, we plot the ten-year Treasury term premium along with the unemployment rate over the last fifty years; the chart shows a strong positive correlation. (The shaded bars represent recessions as defined by the National Bureau of Economic Research.) The chart indicates that the term premium is a countercyclical variable that tends to rise during downturns (when unemployment rises) and fall during upswings (when unemployment falls). This is consistent with standard asset pricing theory, according to which risk premia are higher in “bad states” of the world and lower in “good states.”
The ten-year Treasury term premium is also associated with disagreement between professional forecasters about the level of future bond yields. In the next chart, we plot the same term premium series against disagreement about the level of the federal funds rate four quarters ahead (as measured by the average forecast of the highest ten responses minus that of the lowest ten responses in the Blue Chip Financial Forecasts survey). The latter series is only available from 1982 onward. Both series show a pronounced downward trend in the early part of the sample along with broadly similar short-term dynamics across the sample. This suggests that more dispersion of professional forecasts seems to be associated with higher Treasury term premia....MORE
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