Treasury interest rates are up because they're looking risky

If you want to loan the United States government some money for exactly one year, as of Friday, Oct. 23, the Treasury will pay you a little over 4%. If, on the other hand, you’re willing to tie your money up for ten years by buying a 10-year Treasury note, you’ll get just a hair under 5%.

That’s usually how it goes with government bonds: Short-term rates are lower, and long-term rates are higher. But lately, investors are demanding to be paid even higher rates on long-term government debt.

Treasurys are some of the safest investments out there. If you buy one, you’re going to get your money back when it matures, plus interest. But if interest rates happen to go up, while you’re holding that bond, a Treasury can lose value.

And because of that risk, investors typically require some form of compensation. This is known as the term premium: a little extra yield to compensate investors for the chance that a bond’s value will fall over the long-term.

The longer an investor’s money is tied up in a bond, the bigger a term premium they demand. Imagine you buy a 30-year bond, for instance.

“All kinds of things can happen in the meantime,” said Emanuel Moench, a professor at the Frankfurt School of Finance and Management in Germany. “So the 30-year bond, typically, we think of as having a higher term premium.”

Moench created a model that estimates term premiums have been rising over the last five years. Over the past year, one particular premium on 10-year bonds has almost doubled, from around half a percent to a full percentage point.

John Canavan, lead market analyst at Oxford Economics, said some of that is because investors are concerned about what’ll happen if the government floods the market with new Treasurys to finance the national debt.

“All of this borrowing raises the question of will investors have enough cash flow in order to easily absorb all this debt,” he said.

If demand for government bonds doesn’t keep up with supply, Canavan said bond values might fall.

“And given that risk, we’re going to require some extra yield in response,” he said.

Another factor pushing up term premiums this year is the war in the Middle East, and all of the risks it’s generating.

“That’s caused a re-thinking about what type of geopolitical tensions we might see going forward,” Canavan said. “It’s caused a re-thinking about oil prices going forward, and what that means for inflation going forward.”

Investors also aren’t really clear on how the Federal Reserve is going to react to the current rise in inflation, since Chairman Kevin Warsh has decided that the Fed will be less transparent.

“That means he’s not going to be telling the markets as much as previous Fed chairs did about what they anticipate the Fed funds rate to do going forward,” said Carola Binder, an economics professor at the University of Texas at Austin.

Binder said that means the market is uncertain about short-term interest rates.

“That, in turn, leads to uncertainty about longer-run interest rates,” Binder said. “And that uncertainty increases the further down into the future you go.”

And, once again, when investors are uncertain, they need an extra premium to compensate. That means an even higher term premium, and higher interest rates throughout the economy.