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The world’s negative term premium

The term premium on the “world government bond yield” has turned decisively negative, according to BIS research. Investors have since 2014 accepted a long-term yield below expected short-term rates, rather than charging a premium on duration exposure. The compression and inversion of term premia may have been fueled by a global duration carry trade and seems to be a global phenomenon. It has coincided with increased correlation of long-term yields across developed and emerging markets.

Hördahl Peter, Jhuvesh Sobrun and Philip Turner (2016), “Low long-term interest rates as a global phenomenon”, BIS Working Papers, No 574, August 2016.

The post ties in with the subject of price distortions due to government policies (summary page here) and the systemic risks of non-conventional monetary policies (summary page here).

The below are excerpts from the paper. Headings and cursive text have been added.

The collapse in global government bond yields

“Global interest rates are, according to Haldane (2015), now ‘lower than at any time in the past 5000 years’…There has been a significant and persistent (i.e. presumably non-cyclical) decline in both benchmarks: the Federal funds rate and the world long-term real interest rate.”

“Laubach and Williams (2015)…put the real equilibrium Fed funds rate (or the natural rate) in the range of 3 to 4% in the 1980s, noting that it then declined over the subsequent two decades to about 2%… According to their latest estimates the US natural rate has been hovering around zero since 2010.”

A more comprehensive post on the compression of the U.S. natural interest rate can be found here.
A more comprehensive post on the decline in global equilibrium real interest rates can be found here.

“The world real long-term interest rate has been declining at least since 2000 and probably much longer. It would be implausible to attribute a trend that has lasted for decades to monetary policy alone. In an ambitious study of secular determinants of the world real long-term interest rate, Rachel and Smith (2015) attribute about two-thirds of the fall in global real rates since the 1980s to secular factors that determine desired saving and investment rates.”


The negative term premium

“The yield on US Treasuries can be broken down into the average of expected future 3-month rates over the 10-year life of the bond and the term premium…This separation shows that the term premium in US Treasuries matters more than the average of expected future short-term rates, especially for the emerging economies.”

For a general model on the decomposition of bond yields view post here.

The decline in the world long-term rate since 2008 has been driven almost entirely by a fall in the world term premium (negative in nominal terms since mid-2014). The world short-term rate expected over the long run has fallen only modestly over the past seven years or so, and is now just over 2% (compared with around 4% pre-Lehman).”


“The table [below] shows a persistent decline in the nominal term premium during the past decades: the US 10-year premium was 3% on average in the 1980s, whereas during the most recent five years the average stood at only 0.5%. The corresponding figures for the euro area were 2.4% (for Germany) in the 80s and -0.3% on average during 2011-15…Much of this decline has been due to a fall in the real term premium, which has dropped by over 300 basis points in the case of the United States and by almost 200 basis points in the euro area. In other words, the substantial decline in premia over the past few decades has affected nominal as well as real yields.”


One recent monetary policy contribution to the sharp decline in term premia is the massive central bank purchases of bonds under Quantitative Easing (QE) in the AEs. Large-scale forex intervention by some EM central banks – notably China and commodity-exporting countries –had a similar effect. As their forex reserves reached new highs, many central banks lengthened the maturity of their bond purchases.”

“There is, however, no obvious or simple microeconomic explanation for the persistence of a negative risk premium in holding long-dated paper. Normally, a private investor would see risks in buying assets (in this case, bonds) whose prices have been temporarily boosted by – and yields depressed by – official purchases. Why have they not seen more risks in buying bonds at such low yields?…One clue to the attraction of holding bonds could be the higher term spread (2.38 percentage points in the recent period compared with 0.85 percentage points in a base period). Other things equal, such a large spread would have made interest rate carry-trades (ie borrowing short and lending long) more attractive. If volatility rises sharply, however, such carry-trades can be abruptly reversed. “


Other apparent contributing factors to negative term premia include insurance and pension fund regulation (view post here) and the decline in inflation and rise in deflation risk premia (view post here).

The globalization of term-premium compression

“The cross-country correlations of interest rates have increased sharply, which suggests that purely local determinants (including local monetary policy) have become less important…The term premium seems to matter more for international correlations than the average of expected future short rates, and this is particularly true for the emerging markets.”

“With more stable benchmark policy rates (and stuck at near zero since 2009), long rates have become more important in the global transmission of monetary policy. This is particularly true for emerging market (EM) economies. When most EM foreign borrowing by the private sector took the form of bank loans carrying short-term dollar interest rates, the Federal funds rate was the dominant external monetary influence on financial conditions…The greater use of international and domestic bond markets has made emerging market economies much more sensitive to changes in long-term rates.”


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