Historically, investors have required extra yield to hold longer-term bonds instead of short-term securities to compensate them for the added uncertainty. Thus, in a “normal” world, term premium (TP) should not be persistently negative. Yet, since 2016, TP has been below zero most of the time (top-left chart). A plausible explanation is that a combination of central-bank buying and investors’ unwillingness to take risks has helped push the TP negative as everyone crowds into safe assets. Negative-yielding debt is another symptom of this.

We can see this link between TP and risk tolerance by observing the very high correlation of changes in TP with changes in key inter-market relationships such as small caps vs large caps, copper vs gold or high-yield vs investment-grade debt. This matters as TP is probably reaching the limits of how negative it can realistically be. Back in August 2019, it started to inflect higher as central bankers began calling for fiscal easing and acknowledging the limits of current monetary policy (eg Draghi at the ECB). This allowed reflation trades to start working. Today, without an imminent US recession, and given the low mortality rate of the coronavirus so far, the odds do not favour a collapse in TP again. Fiscal easing is also a medium-term catalyst for a rise in the TP. Thus on balance, strategically, we still favour reflation pair-trades for 2020, even if reflation is temporarily on pause with the coronavirus outbreak.

Source: Bloomberg, Macrobond and Variant Perception