What About the Term Premium?

With all this discussion of the equity risk premium in class, let’s talk a little bit about the term premium.

In our first lecture, we discussed the relationship between the Fed Funds rate and the long-term mortgage rate. We saw that the relationship should be positive. However, we were looking at the period from 2001 to 2004. Now, let’s fast-forward a couple of years to 2006. The Fed has raised rates from 1% to 4.25%. Yet, the long-term rates did not follow. In fact, on 12/27/05 the yield curve inverted for the first time in five years, i.e., long-term rates actually went below short-term rates.

So what caused long-term rates to go down when the Fed Funds rate went up – despite the so-called positive relationship between Fed Funds rate and the long-term rates? This is what an article back from January, 2006 discusses. Notwithstanding its failure at predicting recessions, it brings up three very valid answers to the question posed above:

  1. Bond traders expect inflation to decrease in the long-term, so real rates might reflect a positively sloped yield curve.
  2. There is high demand for long-term bonds, keeping prices high and yields low (we discussed this point in class).
  3. Finally, if interest rates are high at present, and traders expect the rates to fall, the term premium on long-term bonds will fall, reducing yields, making the yield curve flat, or even inverting it. Implicit in this point is that long-term rates are predictions of future short-term rates.

Read the article. It’s also uploaded as a pdf in the ‘Handouts’ section.

In more recent news, there is a discussion going on between two economists at the Cleveland Fed and Paul Krugman (the recipient of the Economics Nobel in 2008). The economists at the Cleveland Fed say that since the yield curve is currently positive (as reflected in the difference between long-term and short-term rates) this is a good sign. It means that the economy will expand.

Professor Krugman disagrees. He restates a version of #3 from above. However, since the Fed currently has the rate set to 0% to 0.25%, traders can only expect the future rates to increase since nominal rates can’t go below zero. So – long-term rates can only go up, since they are a prediction of future short-term rates. He brings up the example of Japan, where the Central Bank kept rates extremely low for a long time (resulting in what is called a “liquidity trap”) yet the economy was in a slump for close to a decade.

The Cleveland Fed economists came back by questioning the assumption – are long-term rates really only future predictions of short-term rates? Not really. Certainly, they are a factor, but there are other things going on there as well. Also, they say, Japan and the US are not really that comparable, for a variety of reasons.

Read the article at the Cleveland Fed if you’re interested in this subject – there are a tremendous amount of data and links there, including the probability of a recession given the difference in short and long-term rates.

Also read Paul Krugman’s article.

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