The New York Fed's model indicates that the 10-year U.S. Treasury term premium has risen to its highest level since 2014. Analysts attribute this trend to widening fiscal deficits, an increase in Treasury supply, and rising geopolitical risks, all of which are prompting investors to demand higher risk compensation. Even if the Federal Reserve shifts to a more accommodative stance, long-term Treasury yields could remain elevated, continuing to weigh on government financing costs and corporate borrowing expenses.
The U.S. Treasury market is sending a signal that is unsettling Wall Street: the term premium has been rising rapidly, serving as a key driver behind this round of Treasury sell-offs and intensifying concerns about persistently high long-term interest rates.
On October 9, Bloomberg reported that in recent weeks, the extra yield investors demand to hold long-term U.S. Treasuries has risen sharply, pushing the 10-year Treasury yield to a 24-year high. According to the New York Fed's model, the 10-year Treasury term premium has climbed to around 0.98%, the highest level since 2014; another model puts it at 1.08%, a new peak since 2010.
The term premium reflects the additional compensation investors demand to bear the risks associated with holding bonds over the long term, including uncertainties related to inflation, fiscal policy, and geopolitics. Even as expectations of future rate cuts intensify, so long as the term premium remains elevated, long-term U.S. Treasury yields may not decline in tandem, potentially keeping government financing and corporate borrowing costs under pressure.
There is no single, clear driver behind the recent rise in term premiums. Expanding fiscal deficits, an increase in Treasury supply, and geopolitical risks could all prompt investors to demand higher yields. Market participants worry that, if these pressures persist, long-term interest rates may struggle to decline significantly even after the Federal Reserve shifts to a more accommodative stance.
Term premiums are rising, driven by multiple factors working in tandem.
Since the term premium cannot be directly observed and must be estimated using models, Minneapolis Fed President Neel Kashkari has likened it to "dark matter." Frank Rybinski, head of macro strategy at Aegon Asset Management, notes that despite differing calculation methodologies, multiple models consistently indicate that the term premium is rising, suggesting that this rally may be sustainable.
Frank Monkam, a macro market strategist at Bloomberg Economics, believes that the term premium has risen to a 12-year high, reflecting mounting fiscal uncertainties and geopolitical risks, prompting investors to demand higher risk compensation.
Short-term technical factors could also exacerbate volatility. Neil Shearing, Chief Economist at Capital Economics, believes that end-of-month portfolio rebalancing, as well as spillover effects from market concerns over France's debt issues, could both exert downward pressure.
Stephen Douglass, Chief Economist at NISA Investment Advisors, noted that pressure in the credit markets and increasingly frequent inflationary shocks are prompting investors to reassess the risks associated with fixed-income assets. He believes that, while short-term volatility should not be overinterpreted, term premiums may be entering a sustained upward trend.
Recently, other factors influencing U.S. Treasury pricing have remained relatively stable: inflation expectations are broadly unchanged, and the Federal Reserve's unanimous decision last month to raise interest rates has to some extent allayed market concerns about its resolve to combat inflation; while oil prices remain above $100 per barrel, their recent volatility has narrowed. Against this backdrop, term premiums have continued to rise, further underscoring heightened investor demand for risk compensation.
Fiscal deficits and geopolitical risks are putting upward pressure on long-term interest rates.
The U.S. annual fiscal deficit stands at roughly $2 trillion, equivalent to about 6% of GDP, remaining at historically high levels despite a low unemployment rate and relatively steady economic growth. Although the Trump administration pledged to cut spending, significantly narrowing the deficit in the short term will not be easy. Persistent fiscal deficits mean the government must continue borrowing, which could further drive up risk premiums on long-term Treasury bonds.
Geopolitical conflicts, in turn, heighten risks of inflation and supply disruptions. Both the Russia–Ukraine conflict and Middle East tensions have previously shaken energy markets. As geopolitical divisions deepen, such shocks could recur, amplifying uncertainty about the inflation outlook and diminishing the appeal of long-term bonds.
Dallas Fed President Lorie Logan said last week that a rise in the term premium would push up borrowing costs and dampen economic activity, thereby potentially reducing the need for the Federal Reserve to raise interest rates further.
However, this does not mean that long-term interest rates will fall in response to a policy shift. Florian Ielpo, Head of Macro at Lombard Odier Investment Managers, notes that even if markets lower their expectations for short-term policy rates, elevated term premiums, inflation uncertainty, and government financing needs are likely to keep long-term U.S. Treasury yields at restrictive levels.
Mark Malek, Chief Investment Officer at Siebert Financial, also noted that the current macroeconomic environment is fraught with risks. Whenever a new risk event emerges, investors reassess the uncertainties associated with holding bonds over the long term and demand appropriate risk compensation.
Editor/lambor