(The opinions expressed here are those of the author, a columnist for Reuters.)
By Jamie McGeever
LONDON, March 7 (Reuters) - As a decade of QE and cheap money comes to an end and many of the world’s big central banks prepare for a changing of the guard, investors fear a rise in the so-called “term premium” on bonds could hurt risky assets like stocks.
They needn’t worry yet, though.
Financial markets have their concerns, for sure. Stretched valuations, fears of bubbles forming, rising interest rates and the threat of extreme bouts of volatility should keep investors on their toes this year.
But few expect the “term premium” - the hard-to-measure extra yield that investors demand to cover any unforeseen events when holding a bond for many years - to return to its historic highs in the near future.
Financial markets like visibility and being able to measure risks. Over a one- to two-year horizon they will feel reasonably confident that they know the path growth, inflation, interest rates and even political risk will take, and they price accordingly.
But if you hold a 10-year security to maturity, there are ‘unknowables’ over that horizon that markets start to demand compensation for.
In recent years, term premiums have been pretty well contained thanks to the trillions of dollars worth of central bank bond buying committed for years into the future.
How serene they will continue to be is another question. QE programmes are winding down amid heightened economic policy uncertainty worldwide, there’s a new chair at the Federal Reserve and several replacements of its policymaking board are due this year. Changes in leadership at the European Central Bank and Bank of England are due next year, too.
Is that enough ‘known unknowns’ to see term premiums start to climb?
The consensus among market watchers and economists is it can stay low. The U.S. 10-year term premium is currently around or just above zero, depending on whose measure you take, but was above 200 basis points as recently as 2013.
A bond yield is generally made up of three components: interest rate risk, credit risk and the “term premium”. Trouble is, there’s no sure-fire way to calculate it, although a rising term premium is a sign investors are discounting a greater degree of risk and uncertainty ahead.
One critical factor to keeping it low is anchoring inflation and inflation expectations. Fundamental to that is market confidence in central banks’ ability to achieve that goal.
All the evidence suggests the Fed and other central banks retain investors’ complete confidence that they will stay “ahead of the curve” on inflation and that policy “normalization” will be gradual and well-telegraphed.
Analysts at Morgan Stanley estimate that around two-thirds of the 50 basis-point rise in U.S. bond yields in January and February to 2.95 percent from 2.45 percent came from rising rate expectations, and just a third from the rising term premium.
“Without signs of sufficient inflation recovery, investors’ demand for term premium remains anchored,” they wrote.
Globally, central banks’ QE unwind has begun. But according to analysts at Deutsche Bank, that won’t switch to outright liquidity withdrawal until the middle of next year.
The central bank backdrop is important because it gives investors confidence that monetary tightening, and by extension any increase in bond yields, will be slow and gradual.
The Fed began to shrink its balance sheet in October last year, but so far the unwind has only amounted to around $40 billion. The ECB isn’t even due to stop its bond purchase programme until September, much less to begin reducing its balance sheet.
Analysts at Swiss bank UBS reckon the Fed will “only” wind down its balance sheet by $900 billion in total, meaning its final level will be around $3.3 trillion, substantially higher than its pre-crisis levels.
Calculations by analysts at Citi suggest that every $500 billion reduction in quantitative easing across advanced economies correlates with a rise in the 10-year global term premium of around 11 basis points.
That’s not a lot.
The Fed has raised interest five times since December 2015 and is expected to raise a further three or four times this year. But the European Central Bank and Bank of Japan are nowhere near raising rates.
Wherever interest rates end up across the developed world once the hiking cycle is over, they’ll be lower than previous peaks, capped by weaker inflation, the lower “neutral” rate of interest and the size of central banks’ balance sheets.
That’s a powerful combination for keeping down interest rate volatility. “This means that term premium should be lower than it was in the previous hiking cycle,” UBS said.
Yield curves are also likely to be flatter than in previous cycles. Good news, if you subscribe to the view that the explosion in market volatility last month that wiped $4 trillion off world stocks was in part caused by a steeper curve.
Yet a flattening curve is also associated with rising official interest rates, which typically come late in the economic cycle. And a mix of slowing growth and rising interest rates is fertile ground for higher market volatility.
So volatility, if not substantially rising term premiums, look like being a feature for markets this year.
Reporting by Jamie McGeever Editing by Hugh Lawson