The U.S. term premium eased over the past week as investors moved into fixed income positions amid the selloff in technology-affiliated equites.
This week we have made the case that financial conditions are not tightening. Rather, they are modestly less accommodative, which implies that there will be more rate hikes by the Federal Reserve than the one that we expect in December.
A quick look at the bond market shows the cause and effect of why the term premium increased notably over the past year.
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First, the bond market selloff started roughly 12 months ago, when the term premium was 0.50.
The term premium increased to 0.96 on Oct. 9 before falling back to 0.75 on Oct. 16 as investors questioned the stability of neocloud computing companies.
The decline was in line with diminished expectations of a rate hike at the Fed’s meeting on Oct. 27-28.
Our fitted 10-year Treasury yield implies a current rate of 5.0746%, which is in line with the 5.1% on Oct. 19.
When and if investor preoccupation with leverage in the AI ecosystem abates, then it is highly probable that yields will rise further as the focus returns to inflation and the sustainability of the fiscal path in the U.S. and other developed economies.
Second, range trading and market stability, characterized by the 10-year trading between 4% and 4.5%, have been shattered.
We are going higher for longer.
Volatility in the bond market since late September has been pronounced—just look at the Bank of America’s MOVE bond volatility index—which is an indication that the yields are permanently resetting up and to the right.
That resetting is a function of the regime change in inflation and interest rates that is now at the core of the American economy.
Third, look no further than the energy shock for the instability that followed the start of the Iran war.
It is one thing to look through short-term supply shocks. But a supply shock that is now in its eighth month cannot be discounted.
Rather, it is a trend that is driving inflation dynamics that need to be addressed via the policy channel.
Given inflation dynamics, we do not see any reason to wait on hiking rates other than the proximity to the midterm elections.
Should inflation increase between now and the December meeting, we think conditions may be ripe for an outsized 50 basis-point hike at the end of the year.
This is why in our estimation financial conditions remain modestly accommodative.
To put the inflation genie back in the bottle, the term premium will have to rise, financial conditions must tighten and the Fed will need to hike rates no matter how much of the heavy lifting the bond market is doing for central bankers.
