I’m sipping my coffee and reading about the term premium, which has just hit a 12-year high. The term premium, for those who don’t speak finance, is a measure of the extra cost of buying long-term bonds compared to short-term bonds. It’s a bit of a wonky metric, but it’s got some investors sweating. The basic idea is that if you’re an investor who wants to buy Treasuries over the next 10 years, you have multiple options available to you. You could buy a 10-year bond, or you could buy a 5-year bond and roll it over halfway through the decade, or you could buy a 2-year bond and roll your investment over five times.
Now, in a perfect world, the cost of buying a long-term bond should be the same as rolling over short-term bonds in the same time period. A decade is a decade, no matter how you slice it. The risk is the same. But we don’t live in a perfect world, and the term premium is reflecting that. Right now, investors have put a significant premium on buying 10-year Treasuries compared to short-term bonds that roll over multiple times throughout the next decade.
The term premium estimates the value of that extra charge, and according to two models, it hasn’t been this high since the spring of 2014. This could be nothing but noise, or it could reflect nervous energy among investors. Or it could signal that the bond market is pricing in even more economic danger than people realize. The International Monetary Fund recently said that rising government debt across the world is becoming unsustainable, and populist economic policies have found favor on the left and the right.
The Iran war has reignited worldwide inflation without a clear endgame, and President Donald Trump has left open the possibility of resuming US attacks on Iran after the midterms. All these factors are sending bond yields to multi-decade highs, raising the cost of borrowing and threatening to slow economic growth. But inflation from AI and fuel shortages may not slow down even if the economy cools off, potentially complicating the government’s ability to intervene with emergency action if necessary.
One unpredictable dynamic that could throw a wrench in the economy’s gears is shifting geopolitics. France may elect its first far-right president since World War II, the UK’s welfare state is crumbling, the Middle East is a powder keg, China and the United States are engaged in a high-stakes battle for AI supremacy, and US midterms could yield unpredictable results in November. It’s a lot to take in, and investors are getting nervous.
As Joe Brusuelas, chief economist at RSM US, said, “It’s important that economists like myself and other capital markets professionals remain humble about our own Achilles heel: its geopolitics. We get it mostly wrong, our models and metrics rarely capture those dynamics and are often behind the curve when things get kinetic.” So, what does it all mean? Well, it’s possible that the term premium is measuring actual risk, or it could be measuring the perception of risk for investors.
It’s also possible that the model isn’t saying what we think it is, and the recent rise in the term premium may have nothing to do with Iran, AI, or debt at all. It could be explained by technical factors, such as large funds rebalancing their portfolios at the end of the third quarter. As Neil Shearing, economist at Capital Economics, noted, “Because the term premium represents the component of a bond yield that cannot be explained by the expected path of short-term interest rates, it is difficult to identify precisely what drives it.”
In conclusion, the term premium is a complex metric that’s trying to tell us something about the economy, but it’s not entirely clear what that is. Investors are nervous, and they’re looking for insurance to park their money over the long haul. As Nigel Green, CEO of DeVere Group, said, “Prices look calm, but people are quietly buying insurance everywhere. Typically, when everyone’s nervous but prices haven’t moved, things don’t adjust gently if the bad news comes; they lurch.” So, buckle up, folks, it’s going to be a bumpy ride. And I’m just going to sit here, sipping my coffee, and watching the financial world go by with a mixture of fascination and horror.
Armchair patriot. Believes in the free market, cold beer, and that there’s always a guy named George behind every CNN segment.
Former remote-throwing champion turned #1 couch commentator on liberal panic in the media. Born in Texas (or so his mug says), he earned a degree in Fake Newsology & Beer Philosophy from YouTube University.
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