Treasuries vulnerable to rising term premiums

Continuing the pattern seen this year, the decline in the yield of 10-year Treasuries over the past month appears to have resulted from a fall in the term premium according to one set of unofficial Federal Reserve data. By contrast, the portion of the yield that reflects investors’ expectations for interest rates has risen slightly further. The premium is now much smaller than it was at the outset of the last monetary policy tightening cycle in 2004. Accordingly, there is much less scope for it to fall sharply and mitigate upward pressure on the 10-year yield once the Fed begins to raise rates. What’s more, there is evidence that the level of the premium is highly correlated with implied volatility in the bond market, which is unusually, and perhaps unsustainably, low.