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Long-term Treasury risk rises on new US fiscal outlook

Rising market expectations for growth and inflation were not the only things behind the selling pressure on US Treasuries after the US election.

One gauge of long-term Treasury market risk known as the term premium has also climbed. The day after the election of Donald Trump as the next US president, the 10-year term premium made its biggest single-day jump since 2011. The move was within the biggest 1 per cent of all daily term-premium changes based data that date back to 1961.

The term premium is an estimate of how much extra return investors demand — or borrowers are willing to pay — for long-term debt, as opposed to short-term securities over the same period. Essentially, it is an attempt to model the risk of unexpected changes in real interest rates or inflation.

It now may be signalling a shift in investor demand for Treasuries, as traders bet that Republican control of Congress could make it easier for the president-elect to implement the infrastructure spending and tax cuts promised in his campaign.

“This could be a pretty big deal if we finally get fiscal easing,” says Priya Misra, head of global rates strategy with TD Securities. “All of the assumptions behind people’s rates views, and what the term premium should be, are challenged.”

The 10-year term premium moved above zero on Monday, according to the Federal Reserve Bank of New York. That broke a 10-month streak where it was negative, which meant traders were willing to pay more to own Treasuries than would be expected if they were looking only at the New York Fed’s forecasts for inflation and real interest rates. One market-based inflation outlook rose 12 basis points in three trading days after the election, and comparable real interest rates climbed 25 basis points.

It is often difficult to pinpoint the cause of changes in Treasury term premiums, however. And big swings are sometimes driven by investors piling into or out of the world’s biggest sovereign debt market. For example, one of the largest recent single-day declines in the term premium happened on November 20 2008. That was the day of a particularly steep drop in the equity market during the financial crisis. It also fell sharply on March 18 2009, when the US Federal Reserve announced it would buy long-term government debt via quantitative easing.

“You could say it’s because [Trump’s plan] is going to blow up the debt and be inflationary, and that’s valid,” says Brian Jacobsen, chief portfolio strategist at Wells Fargo Funds. “You could also say it’s because of increased growth expectations, and because he’s likely to appoint two hawkish governors to the Federal Reserve’s board next year.”

The biggest single-day jump in 10-year term premiums this century occurred on June 1 2009, the day General Motors filed for bankruptcy. The US Treasury was heavily involved in the automaker’s bankruptcy proceedings, which eventually led to a $11.2bn loss for taxpayers. Another large jump happened on October 27 2011, when European leaders’ debt agreement alleviated fears about a breakdown of the currency union.

However, there have been episodes of Treasury term premiums rising that signalled better economic times ahead for the US, as Wells Fargo’s Mr Jacobsen points out.

One came at the end of November in 1961, after the trough of a recession in February. Treasury 10-year yields rose above 4 per cent at the start of the next year, and the country did not experience another recession until 1969.

“Maybe people are beginning to believe the malaise of the past few years is ending,” he says. “If we aren’t stuck in this interest rate pit where rates are zero out to the horizon, borrowers are willing to pay up for longer-term financing.”

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