[Reuters Analysis] How much higher can the US term premium go? A lot: McGeever

By Jamie McGeever

ORLANDO, Florida, May 21 (Reuters) - Financial markets have had a fairly muted reaction to Moody's decision to strip the United States of its triple-A credit rating last week, fueling hopes that the action will do little long-term damage to U.S. asset prices, as was the case when the U.S. suffered its first downgrade in 2011.

But given today's challenging global macroeconomic environment and America's deteriorating fiscal health, that may be wishful thinking. To monitor the impact in the coming months, a key indicator to watch will be the so-called 'term premium' on U.S. debt.

When Standard & Poor's Global became the first of the three major ratings agencies to cut America's top-notch rating in August 2011, there was little blowback because Treasuries were still widely considered the safest asset in the world. Demand for U.S. bonds went through the roof, despite S&P's landmark move, and yields and the term premium plummeted.

That's unlikely to happen now.

In 2011, the U.S. debt/GDP ratio was 94%, a record at the time reflecting a surge in government spending in response to the 2008-09 Global Financial Crisis. But the fed funds rate was only 0.25%, and inflation was 3% but falling. It dropped to zero a few years later and did not return to 3% until the pandemic in 2020.

It's a vastly different picture today. U.S. public debt is around 100% of GDP and projected to rise to 134% over the next decade, according to Moody's. Official interest rates are above 4%, inflation is 2.3% but expected to rise as tariff-fueled price hikes kick in. Meanwhile, consumers' short- and long-term inflation expectations are the highest in decades.

And while the $29 trillion Treasury market is still the linchpin of the global financial system, increasing U.S. policy risk is prompting the rest of the world to rethink its exposure to U.S. assets, including Treasuries - 'de-dollarization' is underway.

HISTORICALLY LOW

Put all that together, and it's easy to see why the 'term premium' - the risk premium investors demand for holding longer-term bonds rather than rolling over short-term debt - is liable to rise after this downgrade, unlike 2011. Especially given its relatively low starting point.

True, the term premium was already the highest in a decade before the Moody's downgrade on Friday, and is now 0.75%, or 75 basis points. But that is still well below the level in 2011 and slim by historical standards.

In July 2011, the term premium on 10-year Treasuries was over 2.0%, but quickly slumped after the S&P downgrade the following month to below 1% and was negative within a few years. Treasuries were downgraded, but their status as the world's undisputed safe-haven asset remained intact.

The last time Uncle Sam's debt or inflation dynamics were as concerning as they are today, the term premium was much higher. It rose to 5% during the 'stagflation'-hit 1970s, and was around 4% following the 'Volcker shock' recessions in the early 1980s triggered by the Fed's double-digit interest rates to quell double-digit inflation.

"The term premium has come up quite a bit recently and is likely going to rise more given the fiscal challenges the U.S. is facing," notes Emanuel Moench, professor at Frankfurt School of Finance & Management and co-creator of the New York Fed's 'ACM' term premium model.

"The worry some investors might have is a self-fulfilling debt crisis – a high debt/GDP ratio increases interest rates, which raises the interest rate burden of the government and means you can't so easily grow yourself out of this anymore. This may push the term premium higher."

FEEL THE SQUEEZE

The question is, how high can it go?

History suggests it can go a lot higher until Washington exerts some serious fiscal discipline, or until the squeeze on households, businesses and the federal government from higher market-based borrowing costs gets too much.

Some analysts reckon another 50 basis points this year, which would take the 10-year yield up to around 5.00%, a pivotal level for many investors and the historical post-GFC high from October 2023.

With fiscal uncertainty so high and policy credibility so low, it's a "tenuous" time right now for Treasuries, as Moench notes. The global environment is nervy too - Japan's 30-year yield this week soared to a record high.

BlackRock Investment Institute strategists point out that long-term Treasuries still carry a "relatively low risk premium versus the past", and their "starting point" in their portfolio construction is to assume a rising term premium and "persistent" inflation pressure. They are underweight long-dated Treasuries.

Treasuries will always attract buyers. It's just that the clearing price they accept may be lower, and the term premium they demand may be higher. The risk now is it's a lot higher.

(The opinions expressed here are those of the author, a columnist for Reuters)

U.S. 10-year 'term premium' vs 10-year Treasury yield

NY Fed 'ACM' model U.S. term premium going back to 1960s

U.S. term premium vs dollar - BlackRock