The fiscal deficit, Treasury supply and important determinants of the term premium

During the past month or so, the ACM measure of the term premium at the 10-year maturity has risen about 25 basis points.  This has apparently generated some concern that the US capital markets may have trouble digesting the flood of pure rates duration supply that appears to be just around the corner, particularly if the Fed were to be hesitant to upside its asset purchase program.

The attached report assesses that worry and concludes that it is not very pressing.  It emphasizes five points in particular, some of which will be familiar to you and some of which are more novel:

  • The outlook for the economy is by no means crystal clear here.  Covid is obviously making a comeback and there are legitimate concerns about how the election will turn out and what the fiscal policy implications of that might be.  But when assessing the influence of the Fed itself, it is crucially important to focus on their objectives, and not on the path of a specific instrument, such as the balance sheet, especially when that influence is secondary, beyond its transitory and behavioral influence on risk-on vs risk-off.  The most important thing here is the thing we already know: the Fed is virtually max dovish. Let’s not waste that happy coincidence.
  • On the specific question of the term premium, the most prominent measure of it – ACM – is systematically inclined to mislead in the current environment, which is characterized by a highly unusual combination, of ZIRP, aggressive rates guidance, a Fed attempting to achieve an unprecedented inflation overshoot, a gigantic (and probably effective) fiscal deficit, and a central bank leadership asking for a larger one.  The mean reversion premise built into conventional estimates of the term premium does not remotely apply here.
  • People, even smart ones like yourself, instinctively conflate the influence of duration supply (and its manipulation via QE) on the term premium with the term premium itself.  That is definitely wrong because the far more important determinants of the term premium are bond yield volatility and the correlation between fixed-income and risk-asset returns.   In fact, bond yield volatility has historically been a more important determinant of even effective pure rates duration risk in the economy than has notional Treasury supply itself. 
  • Importantly, the depressing influence on the term premium of falling bond yield volatility and the shift to a benign stock-bond correlation has probably entirely run its course. As a result, Treasury supply and the Fed’s efforts (or lack of efforts) to mitigate it via balance sheet policy may end up the tiebreaker for the term premium during the coming year or two, especially with Treasury supply set to explode.  If this becomes an issue for the economy, then the Fed will just shift to more QE, most likely.  With or without an offset from the Fed, complete or partial, the prospect of heavy Treasury supply would reinforce what is already the base case in fixed income: the long case is not compelling.
  • For equities, this is much trickier and in a way that is probably counterintuitive. There is actually little reason to believe that a rise of the Treasury term premium driven by supply alone would even be negative equities.  A rise of the term premium driven by deeper fundamentals would very probably be damaging to equities. And people probably have that in mind when getting confused about this issue.  The implication is not that it is clear sailing for stocks. Rather, it is an issue of focusing on the right issues, and Treasury supply is probably not one.