An analysis of the variation of the term premium in the United States Treasury yield curve

The primary causes of variation in the term premium are analyzed within the context of the Expectations Theory of the Term Structure. Changes in the term premium are postulated to be a function of changes in two factors, uncertainty about future interest rates and aggregate risk preferences.; Aggregate risk preferences are shown to be the primary source of changes in term premiums. Variations in the shape of the yield curve are most informative. Although the uncertainty proxies successfully predict volatility, their value in forecasting the term premium was less than that of the shape of the yield curve or the fundamental economic data.; The results indicate that changes in the shape of the yield curve largely reflect changes in term premiums rather than in expectations. The primary cause of term premium changes is the economic cycle. When the economy is above capacity, the yield curve is flat or inverted and subsequent term premiums are worse than indicated by the slope of the yield curve. When the economy has substantial excess capacity, the yield curve is positively sloped and returns are better than indicated by the slope of the yield curve.; These results can be related to risk preferences by the Preferred Habitat Theory. Over the economic cycle, the net demand for funds of different economic sectors changes due to shifts in their risk preferences and their size in the financial market. In an environment of steady but not extreme economic growth, the term premium has historically been negligible beyond six months. It appears that as the economy grows, interest rates increase slowly, offsetting the "yield advantage" of longer maturities with a normal positively sloped yield curve. However, when the economy is at extremes, shifts in the net demand for funds cause substantial movements from normal in the term premium at different maturities. The term premium shifts because many participants require a high premium in order to deviate from their preferred maturity.