Fed says bond market's term premium is the reason behind rise in Treasury yields. Why investors should take it with a dose of caution.

U.S. Federal Reserve officials and some investors are increasingly focused on something that can’t be easily explained by the economy or monetary-policy expectations as a likely driver for the relentless selling of government bonds that has brought long-term Treasury yields to their highest levels in more than 16 years.

See: Long-term U.S. Treasury yields may resume their march higher despite recent bond-market swings, BlackRock says Fed Chair Jerome Powell also nodded to the term premium as a driver for yields. “It’s really happening in term premiums… and not principally a function of the market looking at near-term fund rates,” he said Thursday at the Economic Club of New York on Thursday.However, measuring the term premium is where things get tricky since it can’t be directly observed or calculated.

Mullarkey said the reason Logan and other Fed officials attributed the surging yields to term premiums is they want to show “there’s nothing changed in their previous communications” on their inflation expectations and the path of the interest rates, because a rising term premium can’t be explained by either of these market-moving factors.

Theoretically, the term premium should not remain elevated for long periods of time in the presence of buyers who are able to buy and hold long-term Treasurys to maturity to take advantage of it. In other words, the term premium represents “free lunch” for buy-and-hold accounts because if the premiums are high, it would represent a transfer of income from those who can roll overnights to those who cannot, Axel said in a Wednesday note.

The chart below shows the 10-year Treasury’s term premium looks “remarkably” like the slope of the 2y-10y yield curve, which is odd as the curve flattened and the term premium declined between 2016 and 2018 when the Fed hiked interest rates.

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