Term premium is the only honest
signal left in this cycle.

Every major asset class in the current cycle is contaminated by one or more policy distortions that prevent it from serving as a clean signal about the underlying economy. Equity markets are influenced by share buyback flows, passive index mechanics, and AI sentiment that decouples valuation from earnings. Credit markets are influenced by the residual demand from yield-seeking insurance mandates and the synthetic CDO structures that have quietly re-emerged in the shadow banking system. Short-term rates are influenced by central bank forward guidance that has a political half-life distinct from its economic half-life. The term premium is different. It is the one signal that aggregates all the available information about fiscal supply, inflation uncertainty, and central bank credibility into a single market-clearing price that no single actor controls. When the term premium moves, it is the bond market's honest assessment of whether the policy framework is sustainable.

The desk's current reading of the ACM model term premium, the most widely referenced decomposition of the 10-year Treasury yield into expectation and compensation components, is approximately 1.6 to 1.8%. This compares to a term premium of approximately negative 0.5% in December 2021, which was the low of the QE-era suppression, and approximately 1.1% in October 2023, which was the last time the 10-year yield briefly traded above 5%. The current reading of 1.6 to 1.8% is not historically extreme, but it is elevated relative to the post-GFC average of approximately 0.2%, and it is rising in an environment where the fiscal supply impulse is structurally persistent rather than cyclically temporary.

The desk's full historical analysis of term premium regimes from 1968 to 2024, published in a separate note, identifies three prior regimes and argues that we are in the early stages of a fourth regime characterised by three simultaneous input shocks: fiscal supply, inflation uncertainty, and reaction-function credibility erosion. This note focuses on what the current term premium level implies for cross-asset positioning in the near term, specifically on the question of whether the current 1.6 to 1.8% reading is a stabilisation point or a midpoint in a further reset to 2.5 to 3.0%.

The single most important driver of the current term premium level, and the one most likely to prove persistent, is the fiscal supply component. The US federal government is running a deficit of approximately 6.5% of GDP in FY2026, generating gross Treasury issuance of approximately USD 3.8 to 4.2 trillion per year. The net supply, after accounting for Federal Reserve QT, which is absorbing approximately USD 60 billion per month or USD 720 billion per year of the gross issuance, is approximately USD 2.5 to 2.8 trillion per year that must be absorbed by private domestic and foreign buyers.

This net supply figure is historically unprecedented outside of wartime or acute recession periods. In the 2004 to 2007 expansion, when the economy was growing at a similar nominal pace to today, net Treasury supply available to private buyers was approximately USD 400 to 500 billion per year. The fivefold increase in net supply between the mid-2000s expansion and the current expansion is the primary reason the term premium has reset from approximately 0.5% in that period to approximately 1.7% today.

The term premium's fiscal supply component is not mean-reverting under current policy assumptions because the structural factors driving the deficit are not cyclical. The mandatory spending trajectory, driven by Social Security, Medicare and Medicaid, adds approximately 0.2 to 0.3% of GDP per year to the deficit independently of discretionary policy choices. The interest cost component is self-reinforcing: as the deficit increases and the stock of debt grows, the interest payments on that debt add to future deficits even without any new spending commitment. The desk's model of the interest cost snowball shows that at current yield levels, interest expense as a fraction of GDP will rise from approximately 2.8% in FY2026 to approximately 3.4% in FY2029, adding approximately 0.6 percentage points to the structural deficit purely from the compound interest mechanism.

The implication for the term premium is that the fiscal supply floor, the minimum level of term premium required to attract private buyers for the net supply at prevailing rates, is not 1.6 to 1.8%. It is higher, because the supply trajectory is rising while the buyer base is not growing proportionately. The desk estimates the fiscal supply floor, conditional on the current deficit trajectory and QT pace, at approximately 1.8 to 2.2%. The current reading of 1.6 to 1.8% is therefore below the fiscal equilibrium, which implies that either rates need to rise to attract more supply, or the deficit path needs to narrow, or QT needs to slow. One of these three adjustments will occur.

The inflation uncertainty component of the term premium is the most frequently misunderstood. When inflation uncertainty rises, bond investors demand higher compensation for the risk that the fixed nominal coupon they receive will be worth less in real terms than they currently expect. This is not the same as expecting inflation to be higher. It is expecting the distribution of inflation outcomes to be wider, which is a different risk and requires a different portfolio response.

In the Great Moderation period from 1982 to 2007, inflation uncertainty was low because the Fed had established a credible commitment to 2% that compressed the distribution of inflation outcomes. Investors could buy 10-year Treasuries with reasonable confidence that the real return would be within a narrow range of the nominal coupon. The term premium associated with inflation uncertainty was therefore minimal, approximately 0.2 to 0.3 percentage points.

In the current cycle, inflation uncertainty is structurally elevated for three reasons that did not exist in the Great Moderation. First, the tariff policy environment creates periodic exogenous inflation shocks that are not predictable in magnitude or timing, forcing bond investors to price a wider distribution of possible PCE outcomes. Second, the energy transition is creating cost pass-through dynamics in electricity and industrial energy that interact with the traditional inflation indicators in ways that existing models have not fully captured. Third, the geopolitical restructuring of global trade, specifically the fragmentation of supply chains that the desk has analysed in the Vietnam/Mexico routing note, creates a secular upward pressure on goods prices that was absent during the globalisation-driven goods deflation of 1995 to 2015.

The desk measures current inflation uncertainty at approximately 0.55 percentage points of the term premium, using the Philadelphia Fed SPF interquartile range as the proxy. This compares to approximately 0.2 percentage points in 2018 to 2019, meaning that inflation uncertainty alone has added approximately 0.35 percentage points to the term premium since the pre-tariff cycle. If the tariff environment stabilises and the supply chain restructuring reaches a new equilibrium, this component could compress back toward 0.3 to 0.4 percentage points, which would be term-premium-positive. If a second tariff round escalates trade uncertainty, this component could expand to 0.7 to 0.8 percentage points, which would be materially term-premium-negative for duration holders.

The third component of the current term premium, the reaction-function credibility residual, is the most difficult to quantify and the most contested analytically. The desk's estimate of approximately 0.35 percentage points represents the additional compensation that bond investors demand because they are no longer fully confident that the Fed's reaction function is mechanically calibrated rather than subject to forecasting errors and institutional constraints.

The credibility residual emerged from a specific event sequence. The Fed's characterisation of the 2021 inflation surge as transitory, which was not simply a communication choice but reflected a genuine institutional belief that embedded in its models, delayed the tightening cycle by approximately 12 months relative to the desk's estimate of the appropriate timing. When the tightening cycle eventually began in March 2022, it was the most aggressive since the Volcker era, requiring 525 basis points of hikes in 16 months. The speed and magnitude of the tightening confirmed that the models had failed, and the failure introduced a risk premium into the bond market that compensates for the possibility of a future policy error in either direction.

The credibility residual has two asymmetric components. The downside error risk, meaning the Fed moves too slowly to tighten in a future inflation surge, is priced as an inflation premium that investors demand for holding long-duration nominal bonds. The upside error risk, meaning the Fed moves too aggressively and triggers a recession, is priced as a volatility premium in the rates options market rather than in the spot yield. The combination of both error risk premia is what produces the 0.35 percentage point credibility residual in the desk's decomposition.

The credibility residual is not permanent. It will compress as the Fed accumulates a track record of accurate inflation forecasting and timely policy adjustment under the new regime. The desk estimates this track record requires approximately 2 to 3 more years of confirmed cycle management, meaning the credibility residual will be a persistent feature of the term premium through approximately 2028 to 2029 before beginning to compress toward the Great Moderation level of near zero.

The term premium's role in cross-asset pricing is more pervasive than the bond market commentary suggests. A structurally higher term premium does not just make 10-year Treasuries less attractive relative to bills. It changes the discount rate for every long-duration asset in the financial system, including equity multiples, real estate capitalization rates, infrastructure valuations, and private equity internal rates of return. Understanding where the term premium is in its cycle is therefore a prerequisite for understanding the correct valuation level for all long-duration assets, not just for sovereign bonds.

The first-order implication is for equity multiples. The theoretical relationship between the term premium and the equity risk premium implies that when the term premium rises, equity multiples should compress because the discount rate applied to future earnings increases. In practice, this relationship is messier than the theory suggests because equity earnings grow while bond coupons are fixed, but the direction is robust: a 50 basis point rise in the term premium from 1.7% to 2.2% should compress the S and P 500 forward P/E by approximately 1.5 to 2.0 multiple turns, all else equal. The current S and P 500 forward P/E of approximately 21x is therefore exposed to a mean-reversion risk of approximately 8 to 10% from multiple compression alone if the term premium completes its reset to 2.2 to 2.5%.

The second-order implication is for credit spreads. A higher term premium changes the composition of the all-in yield for corporate bonds: a larger fraction of the yield comes from the duration component and a smaller fraction from the credit spread. This means that credit investors are getting less spread per unit of risk they take, and the appropriate response is to shorten duration in corporate bond portfolios rather than to extend duration to achieve higher yields. The desk's current corporate bond allocation prefers the 3- to 5-year segment over the 7- to 10-year segment, because the term premium risk in the 7- to 10-year segment is not adequately compensated by the incremental credit spread.

The third-order implication is for the valuation of real assets, including real estate and infrastructure. Capitalization rates in commercial real estate have risen from approximately 4.2% in 2021 to approximately 6.5% in 2026, driven primarily by the rise in the risk-free rate component. The desk's view is that capitalization rates have a further 30 to 50 basis points of adjustment ahead if the term premium completes its reset, which implies that commercial real estate valuations are not yet fully adjusted to the new rate regime even after the significant corrections of 2022 to 2025.

The foreign demand score of 73 is the watch variable, because it is the input that can move fastest and has the most direct market impact. The fiscal supply and credibility components move gradually; the foreign demand component can shift in weeks if a major central bank changes its reserve management framework. The desk monitors TIC data monthly and Treasury auction foreign indirect bidder participation at each coupon auction as the primary early warning indicators.