by Lawrence Gillum, CFA, Chief Fixed Income Strategist, LPL Research
Additional content provided by Colby Hesson, Analyst, Research.
Treasury yields have been creeping higher (lower price) lately, and the 10-year yield is currently above 4.0%. Since the middle of September, 10-year yields are up over 0.50%. Most of the move can be explained because the market had already priced in aggressive rate cuts. But better economic data recently has pushed out the prospects of an overly aggressive rate-cutting campaign by the Federal Reserve (Fed). But adding to the move higher in yields is the return of a positive term premium.
According to economic theory, each security on the Treasury yield curve represents the predicted fed funds rate over the security's maturity period, plus or minus a term premium. The Treasury term premium is the additional compensation required by investors who buy longer-term Treasury securities. The term premium, which is unobservable and hence must be approximated, considers a variety of factors, including Treasury supply/demand dynamics, foreign central bank expectations, and the possibility of future inflationary pressures. Additionally, rising term premiums could also indicate markets are betting on higher government deficits depending on election odds.
Treasury Mid Prices Move Back Into Positive Territory
Source: LPL Research, Bloomberg 10/22/2024
Disclosures: Past performance is no guarantee of future results.
The last time a term premium turned positive was around a year ago, in October 2023. The recent increase follows a surge in Treasury yields following solid U.S. jobs data last week, which caused investors to reduce their bets on the size of future interest rate reductions by the Fed. Benchmark 10-year rates, which fell to a one-year low in September on anticipation of monetary policy easing, have subsequently risen to well over 4.2% (as of October 22), reaching their highest level since late July.
So, how does this affect fixed income investors? A positive term premium could keep longer-term interest rates elevated, perhaps reducing the diversification benefits of core bonds. Regarding the former, while monetary policy expectations will continue to be the dominant driver of interest rate changes, Fed rate cuts may not have the desired effect, and longer-term interest rates may not fall as much as they would have without a positive term premium (like we’ve seen recently). In terms of the latter, while we still believe Treasury securities will be the safe haven choice in the case of a broad macro equity market sell-off, they may not be the best defensive option for garden-variety equity market sell-offs.
The LPL Research Statistical and Tactical Asset Allocation Committee (STAAC) believes taking a step back into a neutral bond allocation for tactical asset allocation strategies can help lock in gains on strong-performing sectors, ride out a range-bound rate environment, and weather future economic and geopolitical setbacks. Alternative investments are an appealing option for people wishing to tactically employ the proceeds of such a transaction. Global macro alternatives can provide substantial diversification effects, and multi-strategic alternatives can provide favorable, dynamic, uncorrelated investing.
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