The term premium is the difference between short and long term interest rates. It is one of the most revealing indicators in finance and the macro economy. It captures the markets expectations of future interest rates. If it expects shot-term rates to be higher in the future, longer-term rates today go up today and the term premium rises. This could reflect that the market thinks the Fed will increase rates one day when the economy is stronger. That is why some commentators think a steeper yield curve, and large term premium, signals a positive economic outlook.
But it also could signal trouble ahead. It could be the market anticipates less demand or more supply of bonds, increasing yields. This could mean the days of cheap borrowing could be coming to an end. The term premium also contains a risk premium, or how much investors what to be compensated for taking on interest rate and inflation risk associated with long term bonds. The more worried investors are, the larger the premium.
The term premium is still low by historical standards. But it is rising fast and should be watched.
Allison Schrager is a senior fellow at the Manhattan Institute. Follow her on Twitter here.
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