Abstract :
- Since mid-September 2024, despite the US Federal Reserve (Fed) lowering its key interest rates, long-term US interest rates have been on an upward trend.
- This increase seems to be mainly explained by the evolution of the « term premium, » which had been compressed for years and seems to have been « reawakening » since the end of 2024.
- Uncertainties about future inflation and the Fed’s monetary policy trajectory are partly responsible for this increase in the term premium.
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Between mid-September 2024 and mid-January 2025, long-term US interest rates rose sharply. Ten-year rates rose from 3.6% to 4.8%, reaching their highest level since October 2023, while 30-year rates reached 4.9% on January 14, compared with 3.9% in mid-September. After easing in January, long-term rates tightened again in February.
This increase in long-term rates may seem surprising, as it comes at a time when US monetary policy is being eased. The Federal Reserve has reduced its key rate by 100 basis points since September 2024.
Short-term interest rates are therefore falling, while long-term rates are moving in the opposite direction. However, this situation is not as paradoxical as it seems, particularly following a period of yield curve inversion[1].
This note aims to explore the reasons for the widening gap between short-term and long-term rates by revisiting the predominant role of the « term premium » [2].
Term premium: from key rates to the structure of the yield curve
According to financial theory, interest rates or Treasury bond yields are composed of three main elements: (i) short-term rates, which are directly influenced by the central bank’s key interest rate, (ii) expectations of changes in the central bank’s interest rate over the bond’s maturity, and (iii) the term premium.
The second component determines the level of the risk-free rate. It is based on two assumptions: (i) expectations of the neutral rate[3], influenced by structural factors (e.g., productivity, demographics), and (ii) the degree of monetary policy accommodation, determined by inflation expectations, the labor market situation, and the reaction function of the central bank, in this case the Fed.
The term premium is defined as the return demanded by investors to bear the interest rate risk inherent in Treasury securities. This premium therefore compensates for the risk associated with holding longer-term bonds rather than continuously refinancing bonds with very short maturities. Long-term bonds are generally riskier due to the risk of interest rate fluctuations over their lifetime. Beyond uncertainties about interest rate and inflation trends, the term premium also includes the excess return required to compensate for the risks associated with the illiquidity of longer-term bond markets and price volatility (which is a measure of the risk taken by investors).
This term premium depends mainly on uncertainty about inflation and the real short-term rate. This variable is closely monitored by analysts because it provides key information about investors’ perceptions of future risks, whether inflation, the balance between supply and demand for bonds, or any other factor beyond the expected path of short-term rates.
The term premium is not directly observable and is estimated using econometric models, such as the Adrian, Crump, and Moench model[4], the Kim and Wright model[5], or the Christensen and Rudebusch model[6].
What are the factors behind the recent rise in US 10-year rates?
The 120-basis-point increase in US 10-year rates between mid-September 2024 and mid-January 2025 can be explained by both (i) a reduction in the Fed rate cuts anticipated by the markets and therefore a readjustment of the expected average short-term rates over the next few years, and (ii) an increase in the term premium. According to the Christensen and Rudebusch model used by the Federal Reserve Bank of San Francisco, the expected average short-term rate over the next 10 years rose by 57 basis points, and the 10-year term premium by 63 basis points over the same period.
Firstly, the recent improvement in macroeconomic data in the United States, particularly in the labor market, has delayed expectations of a more « aggressive » rate cut by the Fed. Employment growth in December was well above expectations, with non-farm payrolls rising by 256,000 compared with the 165,000 anticipated by analysts. The unemployment rate fell slightly from 4.2% in September to 4.1% in December. At the same time, US inflation strengthened in December, rising by +2.9% year-on-year, compared with the cycle low of +2.4% in September.
In response to this data set, Fed members adjusted their expectations for rate cuts (communicated to financial markets through their dot plots[7]). The December 2024 dot plots reveal that the US central bank now anticipates a 50 basis point reduction in 2025, half of what was expected in September 2024, when it was concerned about developments in the labor market. Financial market participants have done the same. In mid-January, they were anticipating a terminal rate of 2.8% for the end of 2025, compared with 3.9% in mid-September. In other words, the equivalent of four 25-basis-point rate cuts for 2025 were eliminated in a short period of time.
Secondly, the term premium, which had been compressed for several years on the debt market, is gradually rebuilding due to fears about US fiscal policy under the mandate of newly elected President Donald Trump. At a virtual event on January 9, 2025, Thomas Barkin, president of the Federal Reserve Bank of Richmond, cited the term premium as a reason for the rise in long-term interest rates, as opposed to fears of a resurgence of inflation.
According to the Adrian, Crump, and Moench (ACM) model, the term premium was negative in September and is expected to be around 50 basis points in January 2025 (see chart below). The market is therefore demanding a risk premium for holding long-term debt issued by the US Treasury that has not been seen since 2014. However, it is important to put the current level of the term premium into perspective. Although this premium has narrowed significantly since the Federal Reserve’s quantitative easing policies, its current level is still far from its long-term average (average level of 82 basis points between January 1990 and February 2025 according to the ACM model).
Chart 1 : US 10-year rates and term premium
Source : Bloomberg
What factors are behind this resurgence in the term premium?
The recent rise in the term premium is the result of increased investor uncertainty. This uncertainty primarily concerns inflation and, by extension, the Fed’s monetary policy trajectory. Many of Donald Trump’s proposed measures, such as the introduction of tariffs, tax cuts, and stricter immigration policies, could increase inflation.
Five-year inflation expectations, as measured by the University of Michigan, reached 3.2% in January 2025, one of the highest levels since 2008. As uncertainty increases, investors demand higher returns for holding long-term government bonds. This is because if inflation rises unexpectedly, the central bank could tighten monetary policy again, causing bond prices to fall[8] and resulting in a loss for investors. Thus, the term premium is positively correlated with the volatility of inflation expectations.
In addition, market participants factor uncertainties about the US fiscal situation into the term premium. Donald Trump’s campaign promises described above could increase the US budget deficit (see this Killer Chart on rate transmission).
US government debt already stood at 123% of GDP in 2024, or USD 35,500 billion. Interest paid by the government, together with tax revenues, amounted to USD 169 billion in 2024, a figure that fluctuates with the level of debt but also with changes in interest rates. This sum represents the fifth largest expenditure in the US budget. The market is therefore increasing its yield requirements on the long end of the curve to take account of the budgetary situation and the deficit, which means there is potential for a greater number of issues at the long end of the curve.
Anticipation of potential imbalances between supply and demand may also lead to a higher term premium. The Treasury will be forced to increase its issuance to finance larger budget deficits. On the demand side for Treasury bills, quantitative tightening[9] by the central bank reduces demand, and private investors must therefore absorb more of these bonds.
In 2023, when term premiums previously soared, it appears that this increase was partly due to an imbalance between supply and demand for debt securities. This seems to be revealed by the mixed results of the Treasury bill auction system during this period: the government was offering more debt securities for sale than investors were willing to buy. Today, there would be no such gap between supply and demand. The rise in the term premium is therefore entirely due to investor uncertainty and higher risk compensation requirements in a higher interest rate environment. The prospect of significant public borrowing requirements, combined with the ongoing reduction in the size of the Fed’s balance sheet, is adding to this uncertainty.
After a lull in the rise in long-term rates between mid-January and early February, they resumed their upward trend. This brief respite was due to some signs of a slowdown in the US economy and to Treasury Department guidelines that eased market concerns about an imminent increase in long-term public debt issuance[10].
The debate in the market now centers on whether the recent increase in US term premiums could signal the start of a new sustained uptrend. Arguments include prospects for structurally higher and more volatile inflation due to increased protectionism and geopolitical risks. However, Treasury Secretary Scott Bessent recently expressed the Trump administration’s desire to reduce 10-year rates, rather than short-term rates, indicating an intention to lower the term premium. To achieve this goal, Scott Bessent is counting on lower energy prices and budget cuts involving a reduction in the public deficit.
This could reassure economic agents in the short term. Nevertheless, the relevance of these comments is called into question by the very nature of the term premium, which depends on the uncertainties of economic agents. A global economy marked by greater uncertainty and shocks will necessarily lead to a structural increase in the term premium.
[1] The US yield curve has been inverted in recent years, with a negative spread between 10-year and 2-year rates between July 2022 and August 2024.
[2] See this article by BSI Economics on the yield curve.
[3] The neutral rate is the theoretical policy rate that stabilizes unemployment and inflation in an economy.
[4] Adrian, Tobias & Crump, Richard K. & Moench, Emanuel, 2013. « Pricing the term structure with linear regressions, »Journal of Financial Economics, Elsevier, vol. 110(1), pages 110-138.
[5] Don H. Kim & Jonathan H. Wright, 2005. « An arbitrage-free three-factor term structure model and the recent behavior of long-term yields and distant-horizon forward rates, »Finance and Economics Discussion Series2005-33, Board of Governors of the Federal Reserve System (U.S.)
[6] Christensen, Jens H.E., and Glenn D. Rudebusch. 2012. “The Response of Interest Rates to U.S. and U.K. Quantitative Easing.”Economic Journal 122, pp. F385-F414.
[7] Projections at different horizons of Fed Funds rates by each member of the Fed’s monetary policy committee (FOMC).
[8] Due to the inverse relationship between bond yields and prices. Anticipation of a rate hike implies anticipation ofa potential decline in the face value of the bond in the event of a sale before maturity and/or leads to short-term selling positions, which mechanically tend to weigh down bond prices and push up yields on the same bonds.
[9] A restrictive monetary policy measure, resulting in a reduction in the size of the central bank’s balance sheet.
[10] In its quarterly redemption announcement on February 5, the U.S. Treasury made no changes to the nominal coupon rate or the size of floating rate Treasury bill auctions.
