US treasury term premium: pricing for disaster

Fully Pricing a Trade War, China Demand Shock … and then some

The market price for insurance, as estimated from the term premium, is fully pricing a scenario similar to the combined effect of a full scale US-China trade war and a significant deterioration (2%) in domestic demand within China.

The OECD has recently estimated the cumulative impact on GDP from each of these events through to 2021-22. Whilst significant, the combined impact of these outcomes is unlikely to create a deep recession in the US. The US is a reasonably closed, services oriented, economy in that it is relatively resilient to international economic developments. This is one reason behind President Trump’s repeated utilisation of trade as a means of coercion in international negotiations.

The following illustrates the OECD’s estimated impact for a deterioration in the trade conflict: 

The OECD also estimated the impact of a significant 2% fall in domestic demand in China:

Over a two year period, a significant deterioration in the trade dispute would subtract approximately 0.9% to US growth. A significant disruption to demand in China, in isolation, would cumulatively subtract approximately 1.4% from US growth over a 2 year period. Note that the China demand slow-down scenario assumes that monetary policy is unable to act.

The estimated economic impacts do not make allowance for any special fiscal support which might be forthcoming. For example, the US is supporting soy bean farmers for losses incurred as a result of the tariff dispute via subsidies. Hence, to the extent that the US would stimulate the economy fiscally during an adverse development, the scenarios would need to be even worse to justify the existing pricing.

The US GDP baseline expectation is for growth in 2020-2021 to be 1.9% per annum. Even if the combined effect of a full US-China Trade War and demand shock in China were to take place, there is a significant buffer between this scenario and the outcomes which unfolded or, in the case of Brexit and the Kennedy Slide, were feared, during the only other times when the term premium was this low.

Distortions from international flows and Fed balance sheet activities

Non-conventional use of central bank balance sheets to manage the yield curve as part of stimulus efforts operate by influencing the term premium. Although the Fed has unwound some of its balance sheet, its remaining holdings would still be exerting downward pressure on the term premium, however this is most strongly influential on longer term maturities.

The prospect of the ECB restarting bond purchases in the Eurozone may also be driving capital from European debt in to the US and contributing to the more recent compression in the term premium. More generally, significant monetary accommodation and associated asset inflation may have had the effect of compressing term premium since sentiment strongly deteriorated from late 2018.

The above may go some way to understanding the lower premium observed following the introduction of large scale asset purchases. Nonetheless, the estimated impact of the Fed’s balance sheet activities would not be sufficient to negate the general observation that the term premium is pricing an extreme economic development. Even allowing for these effects, the market is acting materially more defensively than when the Euro faced an existential threat and the Brexit referendum was passed, both of which took place when the US economy was not as strong as it is presently.

Conclusion

There are many looming threats to the recent recovery in the US economy. The term premium for treasury bonds, which can provide an indication of the extent to which the market is concerned for downside risk, is at an extreme. Should the worst-case scenarios not develop, we may expect a significant steepening of the US yield curve. Investors relying on duration to provide a measure of protection to portfolios may wish to consider the implied price for this insurance.