10-YEAR: The US 10-year bond yield (IEF, ILTB) is a bedrock of modern finance, impacting everything from housing to government finances through to stock market valuations. We have seen a dramatic round trip of these yields from under 4%, all the way up to 5% and back again within a year. By many measures this bond volatility has been greater than for equities. The driver of this has been a return of the so-called bond yield term premium (see chart). This has been dormant for a decade, but maybe now returning as bond market supply/demand and Fed intervention questions rise. This may keep 10-year bond yields stickier than the bulls would like.
COMPONENTS: The 10-year bond yield has three main components. 1) A long-term real GDP growth outlook, 2) long run inflation expectations, and 3) the term premium that represents the ‘unobservable’ differences between the first two components and the bond yield. We proxy GDP with the NY Fed trend GDP growth model of 2.2%. This could be a little lower if we use the Fed ‘dot plot’ 1.8% long term GDP outlook. We then use 10-yr break-even inflation at 2.3%, that is also similar to 5-yr expectations. This leaves us between 4.0% and 4.5% and not far from market levels. But does not include the ‘term premium’, that has driven most of recent volatility.
TERM PREMIUM: The term premium is a catch all for all-other risks to holding a bond over the long term. For the past decade this premium has been negative, and a constraint on yields. But this has been the historic exception, with premiums the norm for the prior 30-years. And has changed recently, driving yield volatility. Whether by concerns over supply and demand, as the US deficit stays wide and some overseas buyers look to diversify. Or on the outlook for less Fed interference, whether QE or the more recent QT. Or simply a catch-all for other bond tail-risks.
All data, figures & charts are valid as of 30/01/2024.