Will Treasury Term Premiums Signal Higher Inflation Risk?

There’s no shortage of indicators to monitor for deciding if the expected runup in inflation is a temporary affair or regime shift that signals a longer-term rise in pricing pressure. I recently considered several of the usual suspects, including core inflation and the Treasury market’s implied forecasts, for tracking this risk. But this only scratches the surface of possibilities. Considering options for what might be labeled alternative metrics, the Treasury term premium deserves to be on the shortlist.

The term premium (TP) is one of the three main components for decomposing Treasury yields. The other two – expectations about inflation and the path of short-term rates – tend to draw the most attention. Perhaps that’s because of the three, estimating TP is more challenging. Regardless, it’s worthy of routine attention in the art/science of deciding if inflation risk is rising, falling, or holding steady.

TP, unfortunately, can’t be observed directly and so a model is required. There are many to choose from and if you line up the results you’ll get a variety of results. The good news is that most estimates tend to align in terms of overall trend direction.

Regardless of the model, the basic premise for the many flavors of TP is the same. In essence, TP is an ex-ante estimate of what you’ll earn (or not) for holding longer-term bonds vs. continually rolling over shorter-term securities for the same period as the longer-term maturity. For example: How will your returns differ for holding a 10-year bond till maturity vs. holding 1-year security and rolling it over every year for a decade? This risk is distinct from, say, a standard yield curve analysis, which compares the return from yields over different holding periods.

Former Federal Reserve Chairman Ben Bernanke advises that there are two key factors driving term premiums: “(1) changes in the perceived riskiness of longer-term securities and (2) changes in the demand for specific securities (or classes of securities) relative to their supply.”

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Disclosures: None.

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