Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / Why Central Banks Are Watching the Term Premium Again
Transcript
- Lucas: If you follow bond markets at all, you've probably heard the phrase 'term premium' thrown around — usually in a sentence that sounds something like 'the term premium is behaving strangely'. Luna: And that sentence has been showing up a lot in 2026. Lucas: Exactly. So let's actually unpack what it is, why central banks care about it, and why it matters for anyone who pays attention to interest rates. The term premium is basically the extra yield investors demand to hold a long-term bond instead of rolling over short-term bonds. It compensates for the risk that interest rates, inflation, or fiscal policy might change over a longer horizon. Luna: So it's not the same as the yield curve. The yield curve is about the level of yields across maturities. The term premium is one thing embedded inside those yields. Lucas: Right. A ten-year Treasury yield, for example, can be broken into two pieces: the market's expectation of the average short-term rate over those ten years, plus the term premium. If the term premium is zero, the ten-year yield just equals the average expected fed funds rate. But it's almost never zero. Luna: And for most of the 2010s, it was actually negative. Lucas: That's the weird part. From roughly 2012 through 2020, the term premium on ten-year Treasuries was negative — sometimes as low as minus one percent. Investors were effectively paying a premium for the safety of long-term government bonds, even accepting a yield below what short-term rolling would imply. Quantitative easing was a big reason for that. Central banks buying massive amounts of long-term debt artificially compressed the term premium. Luna: So QE didn't just lower yields — it specifically crushed the term premium component. Lucas: Correct. And then as the Fed started hiking in 2022 and began quantitative tightening, the term premium started to normalize. By mid-2026, the New York Fed's ACM model — that's the Adrian, Crump, and Moench decomposition — puts the ten-year term premium at around 40 basis points. Positive, but still low by historical standards. Luna: Forty basis points. Historically, before the financial crisis, it averaged more like 150 basis points. Lucas: Which raises the question: will it go back to that level? And if it does, what does that mean for the economy? Because a rising term premium isn't just an academic curiosity. It directly feeds into higher long-term borrowing costs for mortgages, corporate bonds, and government debt — without the Fed having to change the policy rate at all. Luna: So it can tighten financial conditions on its own. Lucas: Exactly. And that's why central banks are watching it so closely right now. If the term premium rises sharply, it could do some of the Fed's tightening work for it — or overshoot and cause a recession. But the tricky part is, the term premium isn't directly observable. You have to estimate it using models. Luna: And those models disagree. The New York Fed's model gives one number, but the Kim-Wright model, which is another common one, gives a different reading. Lucas: The Kim-Wright model actually shows the term premium still slightly negative as of July 2026. So there's a real debate about the level. But the trend is what matters more. And both models agree the term premium has been rising since 2022. Luna: So what's driving that rise? Lucas: A few things. One is quantitative tightening. As the Fed, the ECB, and the Bank of England let bonds roll off their balance sheets, the private sector has to absorb more duration — that pushes term premiums up. Another factor is fiscal policy. With US federal debt above 100 percent of GDP, investors are demanding more compensation for the risk that future deficits might lead to higher inflation or higher rates. Luna: So it's partly about supply and demand for duration, and partly about fiscal credibility. Lucas: Exactly. And then there's uncertainty. The term premium also captures what economists call 'uncertainty about the path of monetary policy.' If the market isn't sure where the Fed will take rates, investors want more compensation for bearing that risk. Luna: And we've had a lot of that uncertainty. The Fed paused, then cut, then paused again. The dot plot has been all over the place. Lucas: Which feeds directly into the term premium. So what does this mean for the neutral rate — R-star? Because the neutral rate is typically estimated from the real yield curve. If the term premium is rising, it can distort those estimates. Luna: We actually talked about the neutral rate a few episodes ago. Lucas: We did. But here's the connection: when the term premium rises, the observed ten-year yield goes up even if expected short-term rates haven't changed. If you back out R-star from the yield curve without adjusting for the term premium, you might overestimate how tight policy is. The Fed knows this. That's why their staff models separate the term premium from the expectations component when they estimate R-star. Luna: So a rising term premium could make policy look looser than it actually is. Lucas: Right. Because if the ten-year yield rises solely because of term premium, not because of higher expected rates, then financial conditions are tightening organically. The Fed doesn't need to hike as much. In fact, some economists argue that the Fed's aggressive hiking cycle in 2022 and 2023 was partly a response to the term premium being too low — they had to raise rates to offset the fact that long-term yields weren't reflecting the true cost of borrowing. Luna: That's a fascinating lens. So the term premium was artificially low, and the Fed had to compensate with higher short rates. Lucas: Precisely. And now that the term premium is normalizing, it's doing some of that work. But the question for 2026 and beyond is: how much further can it rise? If it goes to 100 basis points or more, that could significantly slow the economy. The housing market is already sensitive to mortgage rates, and corporate borrowing costs would rise. Luna: Speaking of which — you know, a couple of dollars a month is genuinely what keeps these episodes coming. If walking through the economy with us has made something click, buy me a coffee dot com slash fexingo. It's the listeners who make this ad-free possible. Lucas: Absolutely. And we mean that — it really does. So back to the term premium. There's also an international dimension. The term premium isn't just a US phenomenon. The ECB watches the term premium on German bunds, and the Bank of Japan watches it on JGBs. In the euro area, the term premium has been negative for even longer than in the US, partly because of the ECB's aggressive asset purchases. Luna: But now that the ECB is also doing QT, we're seeing bund term premiums rise too. Lucas: Exactly. And in Japan, the BOJ's yield curve control effectively kept the term premium near zero for years. Now that they've loosened that control, the term premium on JGBs has jumped. That's causing volatility in global bond markets. Luna: So the term premium is becoming a global talking point. Lucas: It is. And one more thing: the term premium also affects the pricing of financial derivatives. Swaps, options, and even some structured products use the term premium as an input. So when it moves, it ripples through the financial system. Luna: Are there any real-world examples where the term premium caused a specific problem? Lucas: Sure. In September 2019, there was a sudden spike in the term premium — or more accurately, a repricing of duration risk — that contributed to the repo market turmoil. Banks that had hedged their mortgage portfolios got caught off guard. More recently, in the UK gilt crisis of 2022, the term premium on long-dated gilts exploded as pension funds were forced to unwind leveraged positions. That was partly a term premium event. Luna: So when the term premium moves quickly, it can trigger forced selling. Lucas: Exactly. And that's why central banks don't just watch it — they try to manage it. Through QE, they deliberately compressed it. Through communication, they try to anchor it. But they can't control it directly. It's a market price. Luna: So where do you see the term premium going from here? Lucas: I think it will continue to normalize slowly, but with spikes. The structural drivers — QT, fiscal deficits, uncertainty — all point higher. But there's a ceiling. If the term premium goes too high, it could trigger a recession, which would then push it back down as the Fed cuts rates and possibly restarts QE. So it's a self-stabilizing mechanism in a weird way. Luna: So the term premium is both a signal and a cause of economic stress. Lucas: Exactly. And that's why it's one of the most important numbers you've never heard of. Next time you see a headline about the ten-year yield moving, remember there's a hidden component inside it that tells you a lot about what investors really think about the future. Luna: And whether they're being compensated for the risk. Lucas: Right. Because if they're not, that's when the trouble starts.