Term Premium Soars to 11-Year High! Focus on This Week's US Long-Term Treasury Auctions

TradingKey - The recent performance of U.S. Treasury auctions has consistently fallen short of market expectations. Data from the New York Federal Reserve shows that the term premium on 10-year Treasuries is now at an 11-year high. 

The term premium, which represents the extra yield that investors demand for the risk of holding long-term bonds, has risen sharply in recent weeks. This trend reflects growing investor concerns about the future size of U.S. debt.

As demand for U.S. Treasuries cools due to increasingly pessimistic expectations about the U.S. deficit, this week's auctions of long-term bonds could lead to a substantial rise in the term premium, potentially triggering significant volatility in equity and bond markets. 

The U.S. Treasury is set to auction a series of bonds this week, including $39 billion of 10-year notes on Wednesday and $22 billion of 30-year bonds on Thursday.

Rising Market Concerns: Will the Term Premium Continue to Surge?

The 10-year term premium, as reported by the New York Fed, has now reached nearly 75 basis points, the highest level in 11 years, whereas about a year ago, this measure was negative. Analysts point out that the surge in the term premium indicates that investors perceive U.S. economic growth, inflation, and the supply-demand dynamics of government securities as uncertain risk factors.

Currently, with increased spending on interest payments for U.S. debt and defense, coupled with the tax reduction plan from the Trump administration that significantly expands fiscal spending, concerns about the sustainability of U.S. debt and long-term inflation risks are intensifying. Economists suggest that the combination of domestic tax cuts and external tariffs, along with rising debt interest expenditures, could lead the Trump administration's budget deficit and borrowing to exceed official projections.

Moreover, the move towards "de-globalization" might prompt significant sell-offs of U.S. debt by countries like China and Japan, which would further increase the term premium. A higher term premium means higher yields, potentially leading to a persistent decline in both equity and bond markets, thus intensifying financing pressures.

Currently, yields on U.S. long-term bonds remain elevated, with signs of a "term premium crisis" beginning to take shape. The 30-year U.S. Treasury yield, which hit a near 20-year high of 5.15% last month, has slightly receded, standing at around 4.94% last Friday (June 6), over 50 basis points above March pricing levels.

Disconnect Between Long and Short Bonds: Experts Advise Avoiding Bonds Over 10 Years

Kathy Jones, Chief Fixed Income Strategist at Charles Schwab, notes that if economic data weakens sufficiently and the Federal Reserve cuts rates, short-term yields could drop significantly. However, long-term Treasury yields are likely to remain high, restrained by deficit expectations, high debt servicing costs, long-term depreciation of the dollar, and concerns about capital inflows.

This aligns with the perspective of Greg Peters, Co-Chief Investment Officer at PGIM Fixed Income, who believes that "the long-end of the yield market is diverging from the broader Treasury market, driven by risk premiums and political factors."

"Overall, a steeper yield curve is the most likely outcome," Jones explains. This would increase the additional yield compensation investors require for the risk of lending long-term to the government, known as the term premium.

Greg Peters recommends avoiding 10-year and longer-dated Treasuries, as they are increasingly influenced by political rather than monetary policy factors. 

Some firms, like Jeffrey Gundlach's DoubleLine Capital, suggest either avoiding or shorting 30-year Treasuries altogether.