The Return of the Treasury Term Premium

Lawrence Gillum | Chief Fixed Income Strategist

Last Updated:

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

Line graph of Treasury mid prices from 1985 to 2024 as described in the preceding paragraph.

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. 

Important Disclosures

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors. To determine which investment(s) may be appropriate for you, please consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk.

Indexes are unmanaged and cannot be invested into directly. Index performance is not indicative of the performance of any investment and does not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

This material was prepared by LPL Financial, LLC. All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.

Unless otherwise stated LPL Financial and the third party persons and firms mentioned are not affiliates of each other and make no representation with respect to each other. Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services.

Asset Class Disclosures –

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

Bonds are subject to market and interest rate risk if sold prior to maturity.

Municipal bonds are subject and market and interest rate risk and potentially capital gains tax if sold prior to maturity. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply.

Preferred stock dividends are paid at the discretion of the issuing company. Preferred stocks are subject to interest rate and credit risk. They may be subject to a call features.

Alternative investments may not be suitable for all investors and involve special risks such as leveraging the investment, potential adverse market forces, regulatory changes and potentially illiquidity. The strategies employed in the management of alternative investments may accelerate the velocity of potential losses.

Mortgage backed securities are subject to credit, default, prepayment, extension, market and interest rate risk.

High yield/junk bonds (grade BB or below) are below investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

Precious metal investing involves greater fluctuation and potential for losses.

The fast price swings of commodities will result in significant volatility in an investor's holdings.

This research material has been prepared by LPL Financial LLC.

Not Insured by FDIC/NCUA or Any Other Government Agency | Not Bank/Credit Union Deposits or Obligations | Not Bank/Credit Union Guaranteed | May Lose Value

For Public Use – Tracking: #647988

Lawrence Gillum profile photo

Lawrence Gillum

Lawrence Gillum, CFA, guides the fixed income view for LPL Financial Research and has over 20 years of investing experience.