The Great Term Premium Mystery: Why It's Still Low Despite Soaring US Debt
- The ValueCritic
- 5 days ago
- 8 min read
In 2025, the US term premium (TP) remains stubbornly low even as the national debt surges past 120% of GDP. This phenomenon has puzzled many macro observers, especially those trained in classical models that link rising public debt to higher borrowing costs. After all, in theory, a ballooning debt load should increase the risk premium investors demand to hold long duration sovereign bonds. And yet, long term USTs remain relatively contained (see chart below), and the TP, which isolates the excess return component, has only modestly risen from near 0.0% to about 0.75% despite a higher debt to nGDP ratio.
So what gives? The answer lies not in textbook debt arithmetic but in the deeper architecture of global finance, a web of liquidity flows, institutional constraints, inflation credibility, and unyielding structural demand for USTs as the world’s reserve collateral. Rather than seeing debt as a threat, global capital continues to treat Treasuries as indispensable instruments, not just investment vehicles, but operational foundations for the entire financial system. This is visibly reinforced by the steady rise in foreign holdings of UST securities, as shown below. Despite fluctuations in geopolitical sentiment and shifting currency reserves, both the top five foreign holders (China, Japan, UK, Canada, Cayman Islands) and the broader RoW (rest of the world) cohort have continued to expand their UST positions. This illustrates the systemic role Treasuries play as the backbone of global collateral and liquidity frameworks.
Understanding why the TP remains low requires us to peel back the layers of monetary plumbing, examine the expectations anchoring inflation, and recognize the constraints that force institutions to keep buying duration regardless of macro noise. It is a story not of market dysfunction, but of rational adaptation to a regime that continues to inspire trust for now. Here’s a full breakdown of what the data is really telling us,
Firstly, What the Term Premium Actually Measures?
The term premium, is the extra yield investors demand to hold long term bonds instead of rolling over short term ones. In theory, this compensation reflects the added risk of committing capital to a longer time horizon, exposure to unexpected inflation, fiscal slippage, rate volatility, and changes in monetary regime. More practically, it acts as a cushion for bondholders against forecast errors and liquidity shocks.
As modeled by Adrian, Crump, and Moench (ACM, above graph), the TP is a residual estimate derived from the observed Treasury yield minus model implied expectations of short rates. It captures everything not explained by rate path expectations, including uncertainty premiums, inflation risk, liquidity dynamics, and shifts in structural demand.
And while fundamentals like debt to nGDP ratios are often cited as core determinants, real-world behavior doesn’t always align. In fact, the Congressional Budget Office (CBO) projects that US interest payments will rise steadily over time, eventually consuming more than 4% of GDP by the 2050s. Yet this has not triggered a massive surge in term premium at least not yet.
This paradox suggests that what the term premium truly reflects is not debt levels, but the credibility and structure of the system issuing it. Thus, according to ACM and BCA decompositions, the 10 yr TP sits around 0.75%, up from near 0% during the QE era but still far below historical norms (approx1.5%+). What we’re seeing is a normalization, not a revolt. The absence of disorderly selling or inflation unmooring reinforces the interpretation that term premium re-expansion is benign. Investors are not demanding high compensation for holding Treasuries despite widening deficits and projected interest burdens, because they continue to trust the institutional scaffolding behind U.S. debt. The TP may be climbing, but it is still a signal of belief, not breakdown.
So What Are The Structural Forces Suppressing TP in 2025?
Global collateral demand: Treasuries are the base layer of the global financial system. They’re not just assets, they’re margin, repo, and insurance. In a post-Basel III regulatory regime, institutions across the globe, from dealer banks to central clearinghouses, require high quality liquid assets (HQLA) to meet capital and liquidity coverage requirements. Treasuries are the gold standard. Their function as repo collateral ensures constant rolling demand for even long dated bonds, and in times of volatility, their demand increases rather than collapses. This collateral utility makes them systematically indispensable, keeping the term premium structurally low regardless of debt expansion. The panels below shows the steady growth of USD denominated claims since 2018, reflecting the foundational role of Treasuries in international finance. The central and right panels highlight the volatility adjusted flows and changes in USD credit allocation. Together, they reinforce the notion that USTs are less about investment returns and more about global liquidity infrastructure. Cross Border Claims By Currency
Reserve currency privilege: USD still dominates trade, capital flows, and pricing. No alternative comes close. As the global invoicing and settlement currency, the USD dollar underpins most international financial activity, from energy to FX swaps to commodities. Central banks and sovereign wealth funds still overwhelmingly allocate reserves to dollar assets, not just for return but for functionality. In this environment, Treasuries serve as the definitive store of liquidity, deep, stable, and instantly repoable across borders. This monetary centrality helps suppress the TP by embedding Treasuries within the operational infrastructure of global finance.
QE memory + Basel III rules: Banks and insurers are still structurally buyers of duration. Price insensitive flows anchor long-end yields. A decade of quantitative easing has permanently altered the behavior of market participants. Central banks, especially the FED. accumulated vast quantities of long-dated Treasuries, flattening the yield curve and compressing risk premia. Even as QT proceeds, institutional memory of this regime persists. At the same time, Basel III regulations require banks to hold High Quality Liquid Assets (HQLA) such as USTs to satisfy liquidity coverage ratios (LCR). Supplementing this, the Supplementary Leverage Ratio (SLR), a post crisis regulatory capital rule, limits overall balance sheet expansion. During acute stress periods (e.g, 2020), regulators provided SLR relief to encourage banks to absorb more Treasuries. Although that relief has lapsed, the experience reinforced Treasuries’ role as balance sheet priority assets. Banks learned they will likely be incentivized, or at least permitted, to expand Treasury holdings in future liquidity events. These rules structurally compel banks and insurers to maintain exposure to long-end sovereign bonds, regardless of spread compensation. The result is a steady flow of duration demand that is only loosely linked to yield levels, helping suppress the term premium even amid rising issuance.
Inflation expectations remain anchored: Cleveland Fed inflation nowcasts, the Survey of Professional Forecasters (SPF), and market-based 5y5y forward inflation breakevens all consistently cluster in the 2.1% to 2.4% range. Despite volatility in energy prices, wage pressure, and fiscal expansion, markets continue to interpret the Fed's policy framework as credible. This reflects strong central bank signaling, moderate wage growth, and well anchored inflation swaps. As a result, the long-term inflation risk premium remains subdued, limiting upward pressure on the term premium even in the face of rising nominal yields.
QT is gradual: Treasury supply is rising, but met with steady demand from money markets, pension funds, and foreign central banks. Since the start of the Federal Reserve’s quantitative tightening (QT) program, net Treasury issuance has increased, yet long-end yields have remained well anchored. This is partly due to robust absorption by institutional buyers: |
Money market funds have rotated heavily into front-end bills and repo, but continue to recycle liquidity into Treasury collateral via the RRP facility and T-bill auctions.
Pension funds remain structurally long duration to match liabilities, and rebalanced toward government securities amid rate volatility.
Foreign central banks have sustained demand for U.S. Treasuries as part of reserve diversification and dollar-anchored capital management.
Data from the US Treasury’s auction results and the TBAC Q125 minutes confirm that indirect bidder participation (a proxy for foreign and institutional demand) remains elevated even as net borrowing exceeds $2tril annually. As illustrated in the chart below, foreign holdings of both short-term bills and long-term Treasuries have held steady as a percentage of total outstanding debt, reinforcing the view that global capital continues to absorb issuance even amid QT. This resilience in demand helps mute upward pressure on the term premium.
While the current environment supports a structurally low term premium, several tail-risk scenarios could provoke a sharp repricing. The most immediate catalyst would be an upward break in inflation expectations, if Cleveland Fed forecasts or market based 5y5y breakevens decisively move above 3%, investors would begin demanding greater compensation for long-term inflation uncertainty. Likewise, if foreign reserve managers such as China, Japan, or oil-exporting sovereign funds began liquidating Treasuries, whether due to geopolitical tensions, balance of payments needs, or de-dollarization motives, the marginal buyer base would thin out, lifting TP.
Another risk is a loss of Federal Reserve credibility. If the Fed is perceived as politicized or constrained in its policy independence, markets would begin pricing higher inflation or volatility risk into long bonds. Finally, supply shocks from tariffs, energy disruptions, or global commodity reconfiguration could introduce stagflationary pressures that current models do not price.
In these scenarios, the term premium could reprice rapidly toward 1.5–2%, driving long-end yields higher and potentially triggering repricing across equity and credit markets. However, investors currently believe in FED credibility, with it continuing to keep rates fairly elevated despite current inflationary pressures being subdued. That action alone helps the FED maintain credibility as investors believe the FED will use whatever tools within its arsenal to control future inflation.
The term premium is rising, but it’s not a panic signal, yet. It reflects a slow unwind of artificial compression from a decade of QE, financial repression, and global demand for safe collateral. The debt may be bigger, but the plumbing still works. |
Importantly, the rise in TP carries nuanced implications across asset classes and policy domains. For equities, a modest drift higher in term premium compresses valuations at the margin, especially in long-duration sectors like technology. However, this can be offset by robust earnings growth and productivity gains. If TP spikes abruptly, though, the resulting discount rate shock could spark broader equity multiple compression.
In Treasuries, a gradual increase in TP is likely to be absorbed smoothly, especially in a macro environment with anchored inflation and decent demand. But if the move is sudden or policy linked, bond market volatility could surge, potentially steepening the yield curve and pressuring real rates higher. From the FED’s standpoint, a rising TP is not necessarily unwelcome. In fact, it eases the burden on short-rate policy by tightening financial conditions through the long end. As long as inflation expectations remain well anchored, the Fed can tolerate moderate increases in TP. But if that rise begins to reflect market doubts about the Fed’s policy framework, independence, or ability to contain inflation, then rate cuts or more aggressive signaling may come into play to restore credibility.
Ultimately, the term premium serves as a barometer not just of debt sustainability, but of institutional trust. As long as global investors continue to see Treasuries as collateral, not credit, the regime holds. But that trust, once shaken, would have far more profound consequences than any fiscal projection ever could. It reflects a slow unwind of artificial compression from a decade of QE, financial repression, and global demand for safe collateral. The debt may be bigger, but the plumbing still works. The real danger isn’t the size of the debt, it’s a loss of trust in the regime that manages it.
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