Generally speaking, long-term yields are higher than shortterm ones as investors expect to receive a '
term premium' to reward them for locking up their capital for longer.
Moreover, the market does not charge a "
term premium." The discount rate, r, is constant and independent of the maturity of the bond.
This month's issue calls attention to the negative
term premium why this factor will limit the appetite by bank treasurers to extend the duration of their securities portfolios to protect against lower rates in the future.
Movements in long-term interest rates can be decomposed into a domestic component that reflects expectations about the future path of short-term interest rates, and changes in the '
term premium'.
Inflation expectations are an important indicator for the FOMC, where many have worried about the slip in the
term premium, and the flattening/inversion in the yield curve, are signaling recession.
And caused individual investors to offer the same in the secondary market, implying that as prices reflect the "
term premium" of payment plans, they will rise across the board.
First, the rise in real yields that had emerged in late summer had persisted and likely reflected a rise in the real
term premium. Second, there had been a fall in the inflation component, which had offset the impact from the rise in real yields.
The most pressing risks are from "rich valuations in financial markets at the global level, notably an exceptionally low
term premium and a growing tendency toward inward-looking economic policies," the report warned.
Long-term rates tend to be higher because lenders tend to demand more compensation for tying up funds for a longer period, something known as the
term premium.<br />When the FOMC changes its overnight rate, short-term rates tend to move in near lockstep fashion.
The ongoing shrinking of the Fed's balance sheet and plenty of issuance should drive up the compensation investors demand for holding longer-term bonds instead of rolling short-term issues, resulting in levels more in line with history for this demanded
term premium. We increase our end-of-2018 10-year Treasury yields forecast to 2.95 per cent from 2.75 expected before.
Third, investors appear to be demanding a higher
term premium in the face of rising inflation expectations - the
term premium is the additional compensation demanded by investors for holding a long term bond over a short term bond.
Referring to that spread, Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, noted at a recent meeting that the
term premium for long-term Treasuries, adjusted for inflation, is currently negative.
