BIS economists see markets as fragile; urge caution.
This is old news, but as we step into the first few trading sessions of the new year, it's worth rehashing that global central bankers are nervous about signs of froth and volatility in the market.
The BIS - that's Bank for International Settlements, the central bank for 60 member central banks and international organizations, from countries that account for roughly 95% of world GDP - published its latest quarterly review last month, the BIS Quarterly Review, December 2014. The headline article, which was widely reported on in the media, was titled "Buoyant yet fragile?" The BIS provided the following summary (emphasis added):
Markets remain buoyant despite mid-October's spike in the volatility of most asset classes. This sharp retreat in risk appetite reflected growing uncertainty about the global economic outlook and monetary policy stance, as well as increased geopolitical tensions. As selling pressure increased, market liquidity temporarily dried up, amplifying market movements.
Markets rebounded quickly as economic concerns faded and some major central banks further eased monetary policy. In particular, the Bank of Japan and the ECB provided further stimulus, while the Federal Reserve ended its QE3 asset purchases. These opposing moves unsettled exchange rates, with the dollar appreciating against most other currencies.
Reprising the August sell-off and recovery in global financial markets, this rapid flip-flop from "risk-on" to "risk-off" sentiment (and back again) suggests that more than a quantum of fragility underlies the current elevated mood in financial markets.
The BIS further cautioned investors and market participants about "this prolonged surge in financial markets over the last two years, occurring against a backdrop of low growth and unusually accommodative monetary policies in advanced economies." This echoes concerns of some Fed economists, as stated in the minutes from the October 29, 2014 FOMC meeting, "that recent developments in financial markets highlighted the potential for shocks to trigger increases in market volatility and declines in asset prices that could undermine financial stability."
The article seems to further suggest that a re-pricing may occur if and when the FOMC raises short-term interest rates, assuming the market aligns its view of future short-term rates to the neutral level represented by the FOMC median forecast of 3.75%. Such a revision should theoretically increase the term premium and the level of the 10yT yield.
The BIS revisits the term premium.
An interesting nugget within the above "Buoyant yet fragile?" article was an update on the BIS economists' own calculation of the term premium on the 10-year Treasury bond .
Despite the Federal Reserve’s exit from QE3, estimates of the term premium on Treasury yields remained deep in negative territory and even declined further. On the 10-year Treasury bond they fell by more than 10 basis points from September to end-October 2014 (Graph 5, left-hand panel, reproduced below).
Market expectations of future US short-term interest rates also decreased. Forward rates for the end of 2015 fell (Graph 5, second panel), and similar developments were evident across the maturity spectrum. Particularly sharp adjustments occurred on 15 October, and they were not reversed during the actual end of QE3. Throughout the year, primary dealers have consistently and significantly forecasted lower future rates than members of the Federal Open Market Committee (Graph 5, third panel). A future alignment of expectations could raise the risk of abrupt adjustments.
The BIS economists calculate the 10-year term premium by decomposing the nominal yield using a joint macroeconomic and term structure model. Their model shows the term premium in the 10yT deep in negative territory since at least mid-2012, having briefly turned positive early in 2014 when the 10yT yield rose above 3.00%. Based on the graph, it appears the BIS is currently estimating the 10yT term premium at about -0.80% to -1.00%. It appears that the BIS is attributing the most recent drop in the term premium to the market's falling expectations of future short term interest rates, and is warning that if those expectations reverse, then the term premium - and likely the 10yT yield - would rise rapidly.
The NY Fed has a different estimate of the term premium.
Compare that to the NY Fed's daily estimate of the same term premium, which is plotted below versus the fitted 10yT nominal yield (the data is available on their website):
The NY Fed's model shows a somewhat similar pattern of changes in the term premium, but they estimate that it has just recently pushed back into negative territory at -0.20%, having been briefly and just barely negative in late 2012.
If the dynamics are roughly similar - at least over this short period of time shown in the graphs above - does it matter if the two term premium estimates are materially different? I would argue that yes, it does, because attributing or projecting a change in nominal bond yields to a compression or expansion in the term premium is a bit meaningless when there is so little agreement on how it should be calculated, what it's value is and what proportion of the nominal yield it makes up over time.
Background on the term premium
For a very high-level overview of the term premium - embedded with a fair amount of my own skepticism concerning its calculation and use - you can see my previous post, The Term Premium: the Economics Version of the Flux Capacitor.
For a more scholarly, less cynical and considerably more authoritative commentary on the term premium, we borrow from a 2007 Economic Letter from the San Francisco Fed, What We Do and Don't Know about the Term Premium, (edited for brevity):
Briefly stated, the term premium is the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds. For example, suppose that the interest rate on the 10-year U.S. Treasury note is about 5.5%, and suppose that the interest rate on the 1-year U.S. Treasury bill is expected to average about 5% over the next 10 years. Then the term premium on the 10-year U.S. Treasury note would be about 0.5%, or 50 basis points.
Thus, a key component of the term premium is investor expectations about the future course of short-term interest rates over the lifetime of the long-term bond. In the example above, the term premium on the 10-year Treasury note depends crucially on financial market expectations about the course of shorter-term U.S. interest rates over the next ten years, a very long horizon. This foreshadows some of the difficulties of measuring the term premium that we will encounter below.
Note that, while we usually think of the term premium as being positive–that financial market participants require extra yield to induce them to hold a bond for a longer period of time–there is nothing in the definition of the term premium that requires it to be so. For example, if some purchasers of long-term debt, such as pension funds, are interested in locking in a fixed rate of return for a long period of time, they could be willing to accept a lower yield on long-term securities (a negative term premium) in order to avoid the risks associated with rolling over their investments in a series of shorter-term bonds with uncertain, fluctuating interest rates. Thus, both the sign and the magnitude of the term premium are ultimately empirical questions.
The article should be read in its entirety, as it talks succinctly and cogently about the issues surrounding the concept and calculation of the term premium. I've reproduced the graph below from the article, which shows how clearly divergent various estimates of the term premium are over time using four different models / methods. (Note: VAR stands for vector auto regression, and Rudebusch-Wu have since revised their model so it looks much more dynamic.)
Term structure theory can't (yet?) tell you how to invest.
That pretty much sums up my issue with analysts (and FOMC members) who forecast yields (or evaluate and determine monetary policy) based on the supposed dynamics of the term premium. At this juncture I think there is so little agreement among the many economists and their models, that to forecast rates based on a change in the term premium - as if it were some tangible, market-priced, quantifiable component of the yield - is to introduce a nebulous variable into what should be a clearer discussion of monetary policy and the market's reaction to its' implementation.
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