The Return of Term Premium: Why Long-Term Yields Are Rising

Decoding Term Premium: What It Is and Why It Matters for Investors

Defining Term Premium

The term premium represents the additional compensation investors demand for bearing the risks associated with holding a long-term bond compared to the strategy of rolling over a series of short-term bonds for the same cumulative horizon. Essentially, it is the payment investors require for committing their capital for extended periods, during which they face uncertainties such as unexpected changes in inflation, interest rate volatility, and shifts in the overall economic landscape. The nominal yield on any bond can be conceptually decomposed into three main components: expectations of future short-term interest rates, expectations for inflation over the bond’s life, and this term premium. The term premium, therefore, captures the compensation for risks beyond just the anticipated path of policy rates and inflation.

Methods of Calculation/Estimation

It is important to recognise that the term premium is not a directly observable market price; rather, it must be estimated using financial models, specifically term structure models. Among the most widely referenced methodologies is the Adrian-Crump-Moench (ACM) model, developed by economists at the Federal Reserve Bank of New York. This model, and others like it, attempt to disentangle the expectations component from the risk premium component embedded in bond yields.

While sophisticated models provide nuanced estimates, market participants also monitor simpler proxies. For instance, the spread between long-term and short-term Treasury yields, such as the difference between the 10-year Treasury yield and the 2-year or 3-month Treasury yield, is often used as a rough indicator of the term premium or the slope of the yield curve. However, these spreads also incorporate expectations about future short-term rates and do not isolate the term premium purely. 

The choice of model and its underlying assumptions can lead to different absolute estimates of the term premium. Nevertheless, the direction of change and the overall trend indicated by various credible models often show a degree of consistency, providing valuable information even if the precise level is subject to some estimation error.

Why Term Premium Matters

The term premium is a critical concept for investors for several reasons. Firstly, it helps explain movements in long-term yields that cannot be solely attributed to shifts in the Federal Reserve’s policy rate or changes in near-term inflation expectations. This is particularly relevant in the current environment where long-term rates have shown divergence from the Fed’s policy path.

Secondly, a rising term premium has direct consequences for financial markets and the broader economy. It means that long-term interest rates can increase even if the Federal Reserve is maintaining steady short-term rates or, as observed recently, even when initiating rate cuts. Such increases in long-term yields lead to lower prices for existing bonds, especially those with longer maturities, impacting portfolio valuations and duration management strategies. Furthermore, since Treasury yields are benchmarks for many other borrowing costs, a higher term premium can lead to increased borrowing costs for consumers and businesses.

Finally, the term premium reflects investor sentiment and perceptions about future economic conditions, inflation risks, and fiscal sustainability. As such, it acts as a market-derived “risk barometer” for long-term debt. Fluctuations in the term premium can signal shifts in investor confidence and perceptions of macroeconomic stability, often preceding or confirming broader market trends. When investors demand greater compensation for holding long-term bonds, it implies they perceive heightened risks on the horizon.

The Recent Ascent: Term Premium in Late 2024 and Early 2025

Recent data reveal a significant upward movement in the U.S. Treasury term premium, marking a departure from the suppressed levels seen for much of the past decade.

Spike to Decade Highs

Estimates from the Federal Reserve Bank of New York’s ACM model show that the 10-year Treasury term premium experienced a notable spike in late 2024 and early 2025. On January 13, 2025, it surpassed 0.8%, reaching its highest level since 2011. By the end of 2024, other analyses indicated the term premium had climbed to a positive 0.49%.

Monthly data from CEIC, also referencing the ACM model, shows a dynamic path: 0.498% in January 2025, a dip to 0.269% in February 2025, followed by increases to 0.391% in March 2025 and 0.615% in April 2025. Daily data from the Federal Reserve Economic Data (FRED) series for the term premium on a 10-year zero-coupon bond indicated a level of 0.5515% as of May 30, 2025, while other Fed commentary noted it stood at 0.5% as of May 2, 2025. These figures, while varying slightly due to specific model versions or data types (e.g., zero-coupon bond specific premium), consistently point to a substantial rise.

Significant Contribution to Yield Increases

This ascent in the term premium was not a trivial development; it accounted for a significant portion of the concurrent rise in long-term Treasury yields. For instance, the increase in the term premium from 0.05% before the September 2024 Federal Open Market Committee (FOMC) meeting to over 0.8% by mid-January 2025 explained more than half of the rise in the 10-year Treasury yield from 3.65% on September 17, 2024, to a peak of 4.79% on January 13, 2025. This occurred even as the FOMC initiated an easing cycle by cutting its target range for the federal funds rate in September 2024.

Departure from Recent Past

The recent levels stand in stark contrast to the deeply negative territory seen during acute stress periods, such as the COVID-19 crisis low of -1.41% or the -1.317% recorded in July 2020 by CEIC. The climb from a mere 0.05% before the September 2024 FOMC meeting to the recent peaks underscores a rapid shift in market pricing.

This decoupling of long-term yields from the Federal Reserve’s immediate policy direction, an easing cycle met with rising long-term yields, highlights the renewed importance of the term premium. It suggests that markets are actively pricing in risks that extend beyond the Fed’s anticipated short-term interest rate path, demanding additional compensation for holding longer-maturity debt.

Table 1: U.S. 10-Year Treasury Term Premium – Recent and Historical Data

A Historical Lens: Term Premium in the 1970s, 1980s, and the Path to Today

Understanding the current resurgence of the term premium benefits from a historical perspective, particularly when compared to periods of high inflation and subsequent eras of monetary policy evolution.

The High Inflation Era (1970s-1980s)

During the 1970s and early 1980s, a period characterised by high and volatile inflation, term premiums were significantly elevated. Investors, facing considerable uncertainty about the future purchasing power of their returns, demanded a substantial inflation risk premium. Data from the ACM model indicates that the 10-year Treasury term premium reached an all-time high of 5.141% in May 1984. Concurrently, estimates for the 2-year term premium were as high as 1% to 2%. Some analyses suggest that the inflation risk premium component within nominal yields was around 3% to 4% during the 1980s. This era firmly established the strong positive relationship between inflation uncertainty and the magnitude of the term premium.

The “Great Moderation” and Declining Term Premium

Following the “Volcker shock” and the subsequent taming of inflation, the term premium embarked on a secular decline that extended from the early 1980s through the Global Financial Crisis (GFC) and beyond. This period, often referred to as the “Great Moderation,” was characterised by more anchored inflation expectations, increased central bank credibility in fighting inflation, and the effects of globalisation, all of which contributed to reducing the compensation investors demanded for inflation risk.

The Post-GFC Era and Negative Territory

The GFC and its aftermath introduced new dynamics that further suppressed term premiums. Aggressive quantitative easing (QE) programmes undertaken by the Federal Reserve and other major central banks involved large-scale purchases of government bonds, directly reducing the supply available to private investors and putting downward pressure on yields and term premiums. 

Additionally, recurrent “flight-to-safety” episodes during periods of market stress increased demand for U.S. Treasuries, while persistently low inflation expectations and, at times, deflationary fears, also contributed to term premiums falling to historically low, and often negative, levels. The COVID-19 pandemic, for example, saw term premiums plunge to record lows, with the 10-year ACM term premium reaching -1.41% according to one source and -1.317% in July 2020 according to another. During this extended phase, the influence of term premium on yield determination was often secondary to the direct impact of central bank policies and prevailing disinflationary or deflationary concerns.

The Current Resurgence in Context

While the recent spike in the term premium to decade highs is a significant development, it is crucial to place current levels in a broader historical context. Values around 0.5% to 0.8% are still considerably below the extreme highs witnessed in the 1970s and 1980s. Moreover, they remain below the long-term historical average, which is estimated to be around 1.48% or 1.465% (median since June 1961). This suggests that while the market is demanding more compensation for risk than in the recent past, the premium is not yet at levels that would be considered high by the standards of earlier, more inflationary eras.

Alternative View on Historical Trends

Recent research from Federal Reserve economists offers an alternative perspective on the long-term behaviour of Treasury yields and term premiums. Standard decompositions of Treasury yields, which typically use the full history of data, attribute a significant portion of the decline in long-term yields since the 1980s to a fall in term premiums. However, an alternative real-time decomposition suggests that term premiums may have fluctuated within a relatively stable range over this period. Instead, this view posits that the trend decline in long-term yields is more attributable to a decrease in the long-run expected value of short-term interest rates.

If this alternative decomposition is more representative of market dynamics, it implies that the recent “return” of the term premium might be more accurately characterised as a normalisation from unusually suppressed levels (driven by QE and other post-GFC factors) rather than a fundamental reversion to a pre-1980s high-premium regime. It could also suggest that fears of term premiums returning to the very high levels seen during the peak inflation years (e.g., 3-5%) might be less founded, unless there is a corresponding significant upward revision in long-run expectations for short-term rates.

The historical behaviour of the term premium is evidently not uniform; it adapts to prevailing macroeconomic regimes and policy environments. The current increase, while notable after years of suppression, must be interpreted against these varied historical backdrops and also in light of evolving academic understanding of its long-term drivers. This nuanced view indicates that simply anticipating a return to 1970s-style term premia might be an oversimplification of complex underlying dynamics.

Unpacking the Drivers: Why Is Term Premium Rising?

The recent increase in the term premium is not the result of a single factor but rather a confluence of economic, policy, and market sentiment drivers. These elements have collectively led investors to demand greater compensation for holding long-term U.S. Treasury securities.

A. Inflation Expectations and Uncertainty

A primary driver for the rising term premium is the evolving landscape of inflation and inflation expectations. After a period of sharp increases, inflation has proven “stickier” and has not decelerated as rapidly as initially hoped by many market participants and policymakers. This persistence fuels uncertainty about the future path of prices, leading investors to demand a higher inflation risk premium. This premium is considered by some to be the most important secular driver of the term premium.

Concerns have also emerged that potential policy shifts could contribute to persistently higher inflation. For example, discussions around new tariffs and changes to immigration policies have been cited as factors that could drive inflation higher. Market-based measures of inflation expectations, such as the 10-year breakeven inflation rate derived from Treasury Inflation-Protected Securities (TIPS), reflected these concerns, rising from 2.03% on September 10, 2024, to 2.40% by January 21, 2025. Survey-based measures, like the University of Michigan inflation expectations survey, also showed a spike, with some commentary suggesting that narratives around future policy were influencing these expectations.

Academic research supports the link between fiscal conditions, uncertainty, and inflation. Studies indicate that sustained increases in fiscal deficits can exert upward pressure on inflation and shift inflation risk curves higher. Separately, economic models suggest that “uncertainty shocks” distinct from purely financial shocks can be inflationary if firms respond by increasing their price markups as a form of self-insurance.

B. Monetary Policy Shifts: The Role of Federal Reserve’s Quantitative Tightening (QT)

The Federal Reserve’s shift from quantitative easing (QE) to quantitative tightening (QT) is another significant contributor. Under QT, the Fed reduces its holdings of Treasury securities and agency mortgage-backed securities, effectively increasing the net supply of these securities that must be absorbed by private investors. Simultaneously, QT leads to a reduction in bank reserves, which represent Fed-provided liquidity in the financial system.

Both of these effects, a larger supply of bonds for the private sector to hold and reduced central bank liquidity, can exert upward pressure on interest rates, including term premiums. While much of the direct research on QT’s market impact has focused on money markets like the repo market, the broader implication is pertinent to term premium. As the Fed, a large and often price-insensitive buyer, steps back, the remaining pool of price-sensitive private investors must be induced to hold the increased supply of government debt. To do so, they naturally demand greater compensation for bearing the associated risks, particularly duration risk for long-term bonds. This increased demand for compensation manifests as a higher term premium.

Indeed, analysis of the repo market during the current QT period has shown an increasing sensitivity of repo rates to Treasury issuance, although this sensitivity remains below the levels observed during the 2017-2019 QT episode. This suggests that while overall liquidity may still be relatively abundant, it is tightening at the margin, and the market is becoming more responsive to supply changes. This dynamic in short-term funding markets can be seen as an early indicator of the broader market adjustments occurring as the Fed normalises its balance sheet.

C. Supply Dynamics: Increased Treasury Issuance

Compounding the effects of QT is the substantial volume of new debt being issued by the U.S. Treasury to fund government operations and cover ongoing fiscal deficits [User Query]. Data for the year-to-date through May 2025 indicated U.S. Treasury issuance of $12.2 trillion, a 0.2% increase year-over-year. Total Treasury securities outstanding reached $28.6 trillion, up 5.7% year-over-year. With federal debt already standing near 100% of GDP, the market is continually tasked with absorbing this new supply.

Table 3: U.S. Treasury Issuance Statistics (YTD May 2025)

Such heavy issuance, particularly of longer-dated securities, can strain market absorption capacity. This is especially true when inflation is elevated and the fiscal outlook is perceived as challenging, leading investors to demand a higher premium for taking down more duration. The mechanics of Treasury auctions also play a role; primary dealers are required to absorb portions of new issues, which can increase their demand for financing in the repo market, further linking supply dynamics to funding conditions.

D. Fiscal Pressures and Policy Uncertainty

The backdrop of ballooning U.S. budget deficits and rising national debt contributes significantly to investor nervousness and, consequently, to a higher term premium. For instance, pre-election forecasts pointed to a potential $7.5 trillion increase in the deficit, and a sustained long-term deficit around 6% of GDP is widely viewed as unsustainable.

These fiscal concerns can feed into worries about “fiscal dominance,” a scenario where the scale of government debt and deficits might pressure the central bank to keep interest rates artificially low to manage debt servicing costs, potentially at the expense of its inflation mandate. Such concerns, even if not immediately realised, can unmoor inflation expectations and lead investors to demand higher risk premiums.

Broader policy uncertainty also plays a role. General nervousness about the future economic direction, including discussions around international trade policies (e.g., tariffs), immigration, and even the perceived independence of the Federal Reserve, can heighten perceived risk and volatility in financial markets. This “cloudier crystal ball” translates into investors requiring more compensation for bearing long-term risks. Academic studies corroborate this, showing that permanent increases in primary deficits tend to raise inflationary pressures and shift inflation risk distributions unfavourably.

E. Investor Risk Perceptions and Market Dynamics

Beyond specific inflation or supply concerns, a more general increase in investor risk aversion regarding longer-term debt is evident. This heightened sense of risk is reflected in the increased compensation demanded for locking up capital over extended horizons.

One notable shift in market dynamics is the changing correlation between stocks and bonds. For many years, U.S. Treasuries exhibited a negative correlation with equities, making them effective hedges in diversified portfolios. However, more recently, this correlation has turned positive at times. For example, the rolling 13-week correlation between the 10-year U.S. Treasury note and the S&P 500 Index moved from a negative 0.72 on November 22, 2024, to a positive 0.39 as of January 21, 2025. If bonds are perceived as less reliable diversifiers against equity market downturns, investors will naturally demand a higher premium for holding them, particularly those with longer durations.

Furthermore, academic research distinguishes between “financial shocks” (like a credit crunch) and “uncertainty shocks” (like geopolitical turmoil or unpredictable policy shifts). While financial shocks are often deflationary, uncertainty shocks can lead firms to increase price markups (contributing to inflation) even as economic output declines. This complexifies the economic outlook and can contribute to higher risk premia.

Finally, international factors, such as rising borrowing costs in other major economies and potential shifts in global investor appetite for dollar-denominated assets, can also influence the term premium on U.S. Treasuries.

Table 2: Key Drivers of Rising Term Premium

Market Ramifications: The Broad Impact of a Positive Term Premium

The re-emergence of a positive and rising term premium is not an isolated phenomenon confined to the arcane corners of bond market analysis. It has wide-ranging ramifications for the trajectory of interest rates, asset valuations across markets, borrowing costs, and overall investment strategy.

A. Trajectory of Long-Term Interest Rates

A fundamental consequence of a rising term premium is that long-term interest rates can, and have, charted a course somewhat independent of the Federal Reserve’s short-term policy rate. This is a crucial shift from periods when long-term yields were perceived to be tightly anchored by expectations of future Fed actions. When the term premium itself becomes a significant and volatile component of yields, it introduces an additional source of upward pressure on long rates, even if the central bank is holding its policy rate steady or signalling an easing bias. Consequently, a higher term premium establishes an elevated baseline for long-term Treasury yields, fundamentally altering the interest rate landscape that fixed-income investors have navigated for many years.

B. Bond Valuations and Portfolio Duration

The most direct impact of rising long-term yields, driven in part by an expanding term premium, is on the prices of existing bonds. Bond prices and yields move inversely; therefore, as yields rise, the market value of outstanding bonds falls. This effect is particularly pronounced for bonds with longer durations, as their prices are more sensitive to changes in interest rates.

This dynamic elevates the importance of duration risk management. A higher and potentially more volatile term premium means that the risks associated with holding long-duration assets are themselves more significant. While a low or negative term premium offered little compensation for taking on duration risk, a positive and rising premium changes this calculus, though it also implies greater potential for price declines if the premium continues to expand.

However, there is another side to this equation. While existing bond holdings may suffer price declines, newly issued bonds or the proceeds from maturing bonds can be reinvested at these higher prevailing yields. Over the long term, this offers the potential for increased income generation, which is a primary driver of total returns from fixed-income investments.

C. Borrowing Costs

U.S. Treasury yields, particularly the 10-year yield, serve as a fundamental benchmark for a vast array of borrowing costs throughout the economy. These include mortgage rates for homebuyers, interest rates on corporate bonds for businesses seeking to raise capital, and various other consumer and commercial loan rates. Therefore, an increase in Treasury yields due to a higher term premium translates directly into higher financing costs for households, businesses, and even government entities. This can dampen economic activity by making borrowing less attractive for investment and consumption.

D. Potential Spillover Effects on Other Asset Classes

The influence of a rising term premium extends beyond the fixed-income market, creating potential spillover effects on other major asset classes.

• Equities: Higher long-term interest rates, propelled by an increased term premium, can act as a headwind for equity valuations. This occurs primarily because the discount rate used to value future corporate earnings rises, which tends to compress price-to-earnings (P/E) multiples. Some estimates suggest that a 100-basis-point change in real Treasury yields is associated with an approximate 7% change in the S&P 500 forward P/E multiple.
  • The nature of the yield rise matters: equities may perform well if yields are rising due to stronger economic growth expectations, but they tend to struggle if the increase is driven by factors like fiscal concerns or an expanding term premium unrelated to growth. Furthermore, the recent shift towards a positive stock-bond correlation means that bonds may offer less of a diversification benefit during equity market sell-offs, a critical consideration for multi-asset portfolio construction. Small-cap stocks may be particularly vulnerable in a higher-rate environment due to typically higher borrowing costs and thinner profit margins compared to their large-cap counterparts.
• Real Estate: The commercial and residential real estate sectors are highly sensitive to interest rate movements. Rising Treasury yields, influenced by term premium, directly impact mortgage rates and the cost of financing for real estate projects, which can reduce affordability for homebuyers and dampen demand for new developments.
  In commercial real estate (CRE), higher borrowing costs can exert downward pressure on property valuations. Capitalisation rates (cap rates), which are a measure of a property’s return, may need to adjust upwards to reflect increased financing expenses and higher perceived risk. This adjustment can lead to lower property values, especially for assets that were acquired at low initial cap rates. Consequently, real estate as an investment may become relatively less attractive when compared to the perceived safety and higher returns offered by Treasuries in a rising yield environment. However, properties with leases that include inflation-linked rent escalations may offer some offset through increased cash flow, partially mitigating the impact of higher rates.
• Commodities: The relationship between interest rates and commodity prices is complex. Generally, higher real interest rates (which can be influenced by the term premium component of nominal rates) tend to exert downward pressure on commodity prices. This is because higher rates increase the cost of carrying inventories (e.g., storage costs for oil or metals), encourage financial speculators to shift capital out of commodity contracts and into interest-bearing instruments like Treasury bills, and can potentially lead to a stronger U.S. dollar, which often has an inverse relationship with dollar-denominated commodity prices.
  • However, commodities also serve as a hedge against inflation. If a rising term premium is primarily driven by heightened inflation fears, this could lend support to commodity prices. Conversely, if an expanding term premium signals broader economic uncertainty or contributes to an economic slowdown, it could negatively impact commodity demand and prices.

The impact of a resurgent term premium is clearly not confined to the bond market. It has far-reaching consequences for asset allocation decisions, risk assessment methodologies, and valuation models across virtually all major asset classes. Traditional inter-asset relationships, such as the historically negative correlation between stocks and bonds, may be challenged in this evolving regime, necessitating a more dynamic and adaptive approach from investors.

Navigating the New Normal: Investment Strategies in a Rising Term Premium Environment

The re-emergence of a significant and potentially volatile term premium necessitates a strategic reassessment for fixed-income investors and asset allocators. Strategies that performed well during decades of declining interest rates and suppressed term premia may prove less effective in the current environment.

A. Portfolio Construction Considerations

Several adjustments to portfolio construction may be warranted:

• Duration Management: A key consideration is managing interest rate risk, often measured by portfolio duration. If the term premium is expected to continue its ascent, leading to higher long-term rates, shortening portfolio duration can help reduce price sensitivity to these increases. This involves shifting allocations towards shorter-maturity bonds.
• Focus on Income: While rising yields cause immediate price declines for existing bonds, they also mean that new investments and reinvested proceeds can capture higher levels of income. Over the long run, income is the largest component of total return from bonds. Investors may therefore wish to emphasise strategies that capitalise on these elevated yield levels.
• Credit Spreads: Recent market dynamics have not only pushed up Treasury yields but have also, at times, led to wider spreads on credit-sensitive bonds (the additional yield over Treasuries that compensates for default risk). For investors with the appropriate risk tolerance, this can make corporate bonds, including high-yield bonds, relatively more attractive. Some high-yield bond segments may offer the potential for equity-like returns but with historically lower volatility.
• Diversification Beyond Duration: The traditional 60/40 stock/bond portfolio, which relied heavily on the diversifying properties of bonds (particularly their negative correlation with equities and sensitivity to falling rates), may face challenges in an environment of rising term premium and potentially positive stock-bond correlations. This underscores the importance of seeking alternative sources of income and diversification. Such alternatives could include inflation-linked bonds (e.g., TIPS, especially short-dated issues like the iShares 0-5 Year TIPS Bond ETF, STIP), commodities like gold, real assets such as infrastructure, and a continued emphasis on short-dated bonds for their lower volatility and income characteristics.

B. Potential Hedging Strategies

For investors seeking to actively mitigate the risks associated with rising interest rates and an expanding term premium, several hedging strategies can be considered:

• Interest Rate Futures and Options: Selling interest rate futures contracts can help lock in current interest rate levels, providing a hedge against rising rates. Alternatively, purchasing put options on bond exchange-traded funds (ETFs) or directly on Treasury bonds can offer downside protection against falling bond prices.
• Interest Rate Swaps: These derivative contracts allow parties to exchange fixed-rate interest payments for floating-rate payments, or vice versa. An investor or corporation with floating-rate liabilities could enter into a swap to pay a fixed rate and receive a floating rate, thereby hedging against a rise in interest rates.
• Advanced Hedging for Issuers: Companies that anticipate issuing fixed-rate debt in the future can employ specific hedging tools to lock in borrowing rates in advance of the actual issuance. Treasury Locks (T-Locks), which are customised derivatives indexed to a specific Treasury yield, or forward-starting interest rate swaps, can fix the Treasury benchmark component of their future borrowing costs.
• Shorter Duration Instruments: As a more passive form of hedging, allocating a greater portion of a fixed-income portfolio to shorter-duration bonds inherently reduces the portfolio’s price sensitivity to increases in market yields.

C. Identifying Opportunities

A changing market environment also creates new opportunities:

• Active Management: Periods of increased market volatility, dislocations in pricing, and shifting correlations can create a more favourable environment for active fixed-income managers. Skilled managers may be better positioned to navigate these risks and capitalise on specific opportunities that arise from market inefficiencies or relative value discrepancies.
• Short-Duration Bonds: These instruments are often highlighted as a compelling tactical allocation in the current environment. They offer attractive income and carry, particularly on the front end of the Treasury curve and in select corporate credits, while exhibiting less price sensitivity to overall rate movements. Active management in this space can also seek to exploit temporary pricing dislocations.
• Inflation-Protected Securities (TIPS): Given the role of inflation uncertainty in driving up the term premium, and the potential for factors like tariffs to add to cost pressures, TIPS can be an effective tool for hedging inflation risk. Front-end TIPS, in particular, may be attractive in this scenario.
• Defensive Equities & Low Volatility Factors: Within equity allocations, if macroeconomic uncertainty and market volatility persist, investors might consider tilting towards low volatility strategies and defensive sectors. Industries such as Healthcare Providers and Utilities have historically shown less sensitivity to changes in economic growth and inflation.

A rising term premium environment signals a departure from the conditions that characterised much of the past decade. Passive investment strategies that benefited from a secular decline in interest rates and persistently suppressed term premia may face headwinds. The focus for fixed-income investors is likely to shift from relying on capital appreciation driven by falling yields towards more active income generation, meticulous risk management, and a broader search for diversification and hedging tools.

Outlook: The Trajectory of Term Premium and Long-Term Yields in 2025

The path ahead for the term premium and, by extension, long-term interest rates in 2025 is subject to a complex interplay of countervailing forces. Several factors suggest the potential for continued elevation or even a further rise in the term premium, while others could lead to moderation or stability.

Factors Suggesting Continued Elevation or Further Rise

• Persistent Inflation: Should inflation prove more resilient than currently anticipated by markets or policymakers, the inflation risk premium embedded in long-term yields is likely to remain elevated or could increase further. The OECD, for example, projected OECD-wide inflation to reach 4.2% in 2025, an upward revision from previous estimates. Sticky inflation would continue to fuel investor demand for compensation against purchasing power erosion.
• Ongoing Fiscal Pressures: The outlook for U.S. fiscal policy points towards continued large budget deficits and a growing national debt. Persistent fiscal imbalances could sustain upward pressure on the term premium as investors demand greater compensation for the perceived risks associated with holding the debt of a highly indebted sovereign.
• Quantitative Tightening Continuation: If the Federal Reserve continues its programme of quantitative tightening (QT) through 2025, the supply dynamics discussed earlier, namely, an increased net supply of Treasuries for the private sector to absorb, will persist, potentially maintaining upward pressure on the term premium.
• Policy and Geopolitical Uncertainty: Elevated geopolitical tensions, ongoing debates and shifts in international trade policies, and concerns surrounding the independence of central banks could keep overall risk perceptions high. Such uncertainty typically leads investors to demand higher risk premia.
• Historical Context: While the term premium has risen from its recent lows, current levels (around 0.5% to 0.8%) are still below long-term historical averages (around 1.48%). This suggests that there could be further room for the premium to move higher if the underlying drivers of risk and uncertainty persist. Some market commentary from early 2025 suggested the term premium was “poised to continue that trend” of rising.

Factors Suggesting Potential Moderation or Stability

• Economic Slowdown: A more significant slowdown in global and U.S. economic growth than currently forecast could alter the trajectory of term premium. The OECD, for instance, projected global GDP growth to slow from 3.3% in 2024 to 2.9% in 2025. A material deceleration in economic activity could dampen inflation expectations and potentially trigger “flight-to-quality” flows into U.S. Treasuries, which could cap or even reduce the term premium.
• Federal Reserve Easing Cycle: While the term premium can diverge from the immediate path of Fed policy, a more aggressive or sustained monetary easing cycle by the Federal Reserve than currently anticipated by markets could eventually exert downward influence. If Fed rate cuts are perceived as effectively stabilising the economy and reducing future uncertainty, this could calm some risk aversion. As of early 2025, market pricing indicated expectations for two 25-basis-point cuts by the Fed in 2025. Longer-term forecasts from institutions like Goldman Sachs projected the Fed to conclude its rate-cutting cycle in June 2026, with its policy rate at 3.5-3.75%.
• Alternative View on Term Premium Behaviour: If the alternative Federal Reserve research suggesting that term premiums tend to fluctuate within a relatively stable historical range (with long-run expected short rates being the main driver of yield trends) proves more accurate, then the recent rise in term premium might be viewed as a normalisation from unusually suppressed levels. In this scenario, further substantial increases might be less likely unless there is a dramatic upward shift in fundamental views about the long-run path of short-term interest rates.

The outlook for “term premium 2025” and the prospect of “long-term yields rising” further is thus highly contingent on the evolving interplay of persistent inflationary pressures, fiscal policy decisions, Federal Reserve actions (regarding both interest rates and its balance sheet), and the broader investor risk appetite. While there is no strong consensus for a significant decline in term premium from current levels, several analysts see the potential for these levels to be sustained or even to edge higher if the underlying risk factors remain prominent. Consequently, vigilance and continuous monitoring of these drivers will be crucial for navigating the fixed-income markets in the year ahead.

Conclusion: Key Insights for Fixed-Income Professionals

The re-emergence of the term premium as a significant and active component of long-term U.S. Treasury yields represents a pivotal shift in the fixed-income landscape. After years of being suppressed by unconventional monetary policies and low inflation, its recent ascent to decade highs, driven by a complex interplay of heightened inflation uncertainty, the Federal Reserve’s quantitative tightening, substantial Treasury supply, persistent fiscal pressures, and evolving investor risk perceptions, signals that market dynamics are undergoing a fundamental change. For fixed-income portfolio managers, analysts, and economists, several key insights emerge from this evolving environment.

Key Takeaway 1: Long-Term Yields More Complex and Independent. The determination of long-term yields has become more nuanced. It is no longer sufficient to primarily focus on the expected path of the Federal Reserve’s policy rate. The market’s collective assessment of long-term risks, encapsulated in the term premium, now acts as a crucial and potentially independent driver of yields. This means that “long-term yields rising” can occur even in the face of a neutral or accommodative central bank stance, a phenomenon observed in late 2024 and early 2025.

Key Takeaway 2: Heightened Uncertainty and Enduring Risk Factors. The primary drivers underpinning the current surge in term premium, particularly inflation volatility, the trajectory of fiscal policy, and the scale of government debt, are themselves subject to considerable uncertainty and political influence. This suggests that the term premium itself may remain a source of volatility in bond markets. The “crystal ball” for long-term rates has indeed become cloudier, demanding a higher premium for peering into the future.

Key Takeaway 3: Strategic Adaptation is Imperative. Fixed-income investors must proactively adapt their strategies to this new reality. The “term premium 2025” outlook calls for more than passive exposure. This includes more dynamic duration management to mitigate interest rate risk, a renewed focus on income generation from currently higher yields, a careful assessment of credit risk in an environment of potentially higher borrowing costs, and an exploration of alternative diversifiers and hedging techniques to navigate increased market volatility and changing correlations.

The era of predictably low and stable long-term interest rates, heavily influenced by central bank actions aimed at suppressing volatility and risk premia, appears to have given way to a more challenging environment. Fixed-income professionals must now operate in a market where risk premia are more dynamic, requiring more sophisticated analytical frameworks and robust risk management practices. Demystifying the concept of term premium and continuously monitoring its drivers are no longer academic exercises but essential components of making informed investment decisions and successfully navigating the evolving bond market.