The maddening task of measuring the term premium

ftalphaville.ft.com/2015/09/04/2139396/the-maddening-task-of-measuring-the-term-premium/

Theres no good way to separate the duration risk premium the compensation investors get for locking up their
money for long stretches rather than constantly rolling it over from a long-term bond yield, although plenty of
people try.
A recent blog post by economists at the New York Fed gives a flavour of the challenge. You can see their results in
the following chart, which attempts to decompose actual 10-year interest rates (blue) both now and in the future into
pure measures of expected short-term interest rates (red) and what they call the term premium (yellowish):
We dont pretend to have a better method of extracting the
duration risk premium but some of these results seem fishy.
First, notice the red line in the upper-left panel looks almost
exactly like a chart of the Fed Funds rate, plus some
constant. Put another way, this methodology implies that, at
any given point in time, the expected average level of short
rates for the next decade is basically the same as the level of
short rates today plus what looks like some fixed amount.
Thats a weird thing to expect! The level of short rates is
cyclical and the cycle is typically much shorter than 10 years.
According to the National Bureau of Economic Research, the
average US cycle lasts about 4-6 years, although the cycles
have tended to get a bit longer more recently.
Structural changes in the expected rate of long-run real
growth and/or the rate of inflation would affect both short
rates and the expected average level of future short rates, but
those dont happen every time the Fed decides to ease or
tighten. The implied risk premium is therefore probably wrong.
When longer-term rates do rise rapidly with short rates, such as in the first part of the 1994-5 tightening cycle,
changes in the duration risk premium probably play a bigger role. Back then, for example, we can attribute some of
the increase in long rates, and their subsequent decline, to ultra-leveraged investors blowing up as short-term
borrowing costs rose. That distressed selling created a brief opportunity to lock in higher rates than were justified by
pure fundamental expectations, which is the same as saying the duration risk premium spiked. Yet if you look at the
model the risk-adjusted yield went up and the duration premium fell.
Now look at whats implied by the upper-left panel for the past 15 years. The risk-adjusted 10-year bond yield
supposedly collapsed in the early 2000s and then soared in the mid-2000s, while the actual bond yield stayed
relatively stable thanks to massive unobserved movements first up, and then down in the duration risk
premium.
That could be a reasonable approximation of reality, but it seems more plausible to think people in 2000 already
expected short rates to fall because the curve was seriously inverted, while people in the mid-2000s already
expected short rates to rise because the yield curve was so incredibly steep. This isnt to say the duration risk
premium was constant over the past 15 years, just that the premium implied by this model is probably wrong.
Similarly, changes in the premium by themselves probably dont explain the supposed conundrum even if they
possibly contributed to it.

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Another odd result of this model is the flat red lines in the bottom panels. While the level of short-term interest rates
at any specific point in time is strongly affected by the central bank, over time short rates should average out to
something close to the real growth rate plus the inflation rate. The implication is the risk-adjusted yields (red lines)
ought to be based on longer-term expectations for nominal GDP growth.
But the flat red lines in the bottom panels tell us longer-term expectations for NGDP growth were basically constant
between 1960 and 2015. In other words, the model implies investors in 1960 expected the average inflation rate in
1980-1990 to be the same as what investors in 1970 expected for 1990-2000 and what investors in 1980 expected
for inflation in 2010-2020, etc. Thatdoesnt seem plausible
(Also, its not obvious why long-run expectations of real growth would hold steady either.)
The Great Inflation and Great Disinflation were significant because they involved radical changes in peoples longterm expectations and changing those expectations was very painful. Suppose the model is right, though, and
people really believed the huge changes in inflation were just short-term cyclical noise that would disappear after a
few years. If so, why did the economy experience such high unemployment when inflation slowed down from
double-digit rates? Why did the housing sector, which is particularly sensitive to the longest-term interest rates, get
hit so badly by the Volcker tightening?
Our guess is the model used by the New York Fed researchers doesnt disentangle changes in long-term
expectations of the rate of inflation from long-term expectations of the volatility of inflation, which is tricky since the
two tend to be related. (More here.)
None of this is to dismiss the existence of the duration risk premium, because its definitely a real thing. Moreover,
changes in this premium are surely responsible for a significant chunk of what happens to longer-term bond yields.
We broadly agree with the New York Fed economists that the duration premium rose in the 1970s and gradually fell
in the 1980s and 1990s. However, our scepticism of some of the findings of this model should hopefully illustrate the
dangers of putting too much faith in any particular estimate of the duration risk premium.

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