Bond term premiums and macro factors

The term spread has been used as a good tool for predicting recessions. When short rates are above long-term rates, there is a greater chance for a recession in the coming quarters.  We also know that the term premium or the difference between long rates and the average of future short rates will have to be related to yield or term spreads. These are all related to economic factors.

The term spread = expectations between short + long rates and a term premium. The expectations will related to the components of nominal interest rates, expected inflation and expected real rates. The term premium will have to be related to the risk premium in inflation and real rates. More generally, the term premium is related to macro factors of risk with inflation and real rates. There can also be a risk premium with the bonds themselves, supply and demand characteristics but those may be harder to measure.

Researchers have found that term premiums will increase with macro risk. Since investors may not know the length of any recession, it make sense that they will want greater compensation for holding a longer-term bond.  Similarly, if there is greater uncertainty about interest rate forecasts there will be a higher premium. The long-rate is the average of short rates, so less uncertainty on future short rates will translate into less risky bonds. Risk premiums will also be rated to the volatility or uncertainty in bonds. If there is lower risk with holding bonds, the term premium will also decline.

With bond volatility declining, less uncertainty about where short rates will be, and no recession since the market turn in 2009, it should not be surprising that risk premiums have continued to slide. The issue is whether this slide has been good greater or whether conditions will change to force premiums higher. We now have to ask three questions:

1. Is there a chance of an economic downturn increasing or decreasing?
2. Is there a chance of more futures short rate uncertainty?
3. Is there a greater likelihood of more bond volatility?

I would say that the answer to those three questions is yes. Hence, the likelihood of term premiums increasing will be higher. We are seeing that effect in Europe with the reversal in bonds and we expect that it will also happen to a greater extent in the US.