Financial markets often provide valuable insights into the future trajectory of the economy, as they reflect the collective wisdom of numerous investors who invest based on their economic forecasts.
One commonly observed indicator in this context is the yield curve. The treasury yield curve is a visual representation of the cost associated with the federal government’s borrowing over different time periods. It shows the interest rates on government securities at various maturities at a specific point in time. It’s referred to as the risk-free yield curve due to the minimal risk associated with government bonds, considering the government’s ability to repay debts in its own currency. In contrast, debt issued by other entities, such as other government levels or corporations, is typically traded at a spread above the government curve.
Why the yield curve usually slopes upwards
Investors typically demand a premium for making longer term loans. This arises due to the heightened risk they undertake when committing their funds for extended periods, mainly due to the increased difficulty in accurately forecasting economic conditions such as inflation, global economic dynamics, and central bank policies.
This risk premium can be observed in the difference in yield between a 10-year Treasury bond to the earnings from continuously renewing the estimated one-year rate over ten years. With a positive term premium, the yield curve slopes upwards.
The term premium is not directly observable; it is estimated. The Federal Reserve has developed models for estimating the term premium across the yield curve by running regressions. The ACM model, named after the economists who devised it, accomplishes this solely with data on yields. Presently, it suggests that the term premium is positive for the first time since 2017:
Source: Federal Reserve Bank of New York
In a recent speech, Dallas Federal Reserve President Lorie Logan noted that higher term premiums leads to elevated term interest rates, even with the same fed funds rate in place, assuming other factors remain constant. Consequently, if term premiums were to rise, they could assist in moderating the economy, reducing the necessity for additional tightening of monetary policy to accomplish the objectives set by the Federal Open Market Committee (FOMC).
Fed Chair Jerome Powell also focused on the term premium as a factor behind rising yields. “It’s really happening in term premiums… and not principally a function of the market looking at near-term fund rates,” he said at the Economic Club of New York last week.
The inverted yield curve
A yield curve inversion occurs when short-term interest rates are higher than longer-term interest rates. Typically, when the yield curve inverts, investors are pricing in rate cuts large enough to offset the term premium. However, as can be seen in the chart above, term premiums have been negative. Given term premiums are considerably below the historical average, fewer rate cuts are required to invert the curve.
Historically, yield curve inversions have preceded economic recessions. In February, Goldman Sachs suggested that current inversion may not signal a U.S. recession. Their view is that if the economy remains resilient then we are likely to see investors revise their expectations and we will see a more modest inversion. Given the recent adjustment in term premium, it looks like they may be right.
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