Trade shock has turned into financial shock in the form of a rising term premium as investors unwind risk and diversify away from dollar-denominated assets. It’s all happening as the independence of the Federal Reserve has increasingly become at risk.
Since the cyclical low of minus-0.33, the term premium has risen to 0.64, an increase of just under 1%, which we think is mostly a function of risk linked with holding dollar-denominated assets such as Treasury notes.
Adding to the pressure is the growing concern surrounding the independence of the Federal Reserve, a development that only detracts from the attractiveness of holding Treasuries and dollars as a reserve asset.
While the recent strain related to the unwinding of basis and swap trades has subsided, we are now moving into a more risky phase of the trade policy’s rollout.
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The rise in real yields, inflation expectations and the term premium all denote the increasing risk associated with holding Treasuries. In addition, headline risk linked to the Fed’s independence and evolution of the trade war have put investors on edge, which is not conducive to restoring financial stability.
One hopes that some kind of agreement will be reached, which will permit the Fed to restore financial stability and the administration can turn its attention to tax and regulatory legislation.
