Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

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lack_ey
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Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by lack_ey » Mon Oct 23, 2017 8:01 pm

Frequently it's said that the bond market prices in information about future Fed funds rate increases and other action, potential Fed unwinding of the balance sheets, economic conditions, growth, etc. And that's true—the information is known to those transacting in the markets and is reflected in pricing. However, that doesn't tell us exactly why they're settling for the current prices. Are bond investors at any given moment more scared of reinvestment risk or inflation risk, or something else? What's the balance? How is the term risk being priced?

Overall this is related to the concept of the term premium and why on average we've seen higher returns from longer-term bonds than shorter-term bonds in the 20th century. It's a driving force behind why one would use bonds rather than cash to derisk portfolios.

As Ben Bernanke put it in a 2015 article here,
To explain the behavior of longer-term rates, it helps to decompose the yield on any particular bond, such as a Treasury bond issued by the US government, into three components: expected inflation, expectations about the future path of real short-term interest rates, and a term premium.
...
Briefly, a term premium is the extra return that lenders demand to hold a longer-term bond instead of investing in a series of short-term securities (a new one-year security each year, for example). Typically, long-term yields are higher than short-term yields, implying that term premiums are usually positive (investors require extra compensation to hold longer-term bonds instead of short-term securities).
The term premia of Treasuries across the yield curve cannot be directly observed, but can be estimated. The higher the value, the lower the price (higher yield) for longer-term bonds relative to what you'd get investing in short-term bonds and rolling those over.

One of the more-cited models for the yield curve term structure these days, building on decades of work since the expectations hypothesis and other earlier ideas that are widely regarded as empirically untrue now, is from Adrian, Crump, and Moench (ACM) of the New York Fed. They have a post here with some details, a link to updated data, a link to a paper explaining the estimation methodology, and a comparison to some other models and estimates.

For example, one alternative way to derive a term premium estimate would be to take expert surveys of expected short-term interest rate paths and compare those to current longer-term rates. Not all of the methods and models agree, and any one model may be substantially wrong.

All that said, I thought it would be interesting to go back and check what the ACM model is saying these days. I haven't checked it in a while. It does more than just estimate the term premia, but that's one of the things that falls out of it (as the difference between fitted Treasury yields and the risk neutral yield).

So I downloaded the data and graphed for the 2-year, 5-year, and 10-year Treasury bonds:

Image
(click for larger, updated 2017-12-12)

Turns out we're back to negative term premia according to this particular model, which effectively posits that currently the market is pricing Treasury bond yields so high that holding short-term T-bills would be expected to return more over time (averaged over potential futures). I can't tell you if this is actually correct, and I have no comments on the methodology for now, but I thought it was worth at least a look and possibly some discussion. No, I am not suggesting wholesale market timing.
Last edited by lack_ey on Tue Dec 12, 2017 1:43 pm, edited 3 times in total.

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by lack_ey » Sat Nov 18, 2017 1:47 pm

Updating. Also to bump for a little more exposure, especially given some other threads around.

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by patrick013 » Sat Nov 18, 2017 2:23 pm

There's several articles every month but they all point to similar
observations depending of who has written them.

Federal Debt held by the public should rise to 90% of GDP.

Increased demand will keeps spreads down to 1% for TRSY 10
for the foreseeable future.

FFR will rise peaking in several years.

Projections of Interest Rates | Congressional Budget Office
The Budget and Economic Outlook: 2017 to 2027 | Congressional Budget Office

So as the FFR rises we will not see a 2% spread for awhile. Other economic factors
are just being trumped by more and more demand. If the FFR spikes or crashes that
would certainly be a new development. If the money going to TRSY's went to stocks
in confidence that would increase TRSY spreads as demand lessens. That's how it
makes sense to me.
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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by SimpleGift » Sat Nov 18, 2017 2:56 pm

lack_ey wrote:
Mon Oct 23, 2017 8:01 pm
Are bond investors at any given moment more scared of reinvestment risk or inflation risk, or something else? What's the balance? How is the term risk being priced?
Isn't this a case of the U.S. Fed raising short term rates, but international investors piling into longer term Treasuries (driving their prices up and their yields down) — since their home country government bond yields are so low? This table shows the recent yields of longer term bonds in Europe, Japan and the U.S.:
In a world where there's relatively free movement of capital between countries, global bond investors are not just looking at U.S. reinvestment risk or inflation risk (though a consideration, for sure), but rather how the U.S. debt market compares with other developed country debt markets. Right now, U.S. Treasury yields are quite compelling.

If this is right, then as long as central banks in Europe and Japan are still "quantitatively easing" in their domestic economies — and the U.S. Fed is raising short term rates — the U.S. term premium may continue to be low or negative.
Cordially, Todd

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by lack_ey » Sat Nov 18, 2017 3:18 pm

SimpleGift wrote:
Sat Nov 18, 2017 2:56 pm
Isn't this a case of the U.S. Fed raising short term rates, but international investors piling into longer term Treasuries (driving their prices up and their yields down) — since their home country government bond yields are so low? This table shows the recent yields of longer term bonds in Europe, Japan and the U.S.:
In a world where there's relatively free movement of capital between countries, global bond investors are not just looking at U.S. reinvestment risk or inflation risk (though a consideration, for sure), but rather how the U.S. debt market compares with other developed country debt markets. Right now, U.S. Treasury yields are quite compelling.

If this is right, then as long as central banks in Europe and Japan are still "quantitatively easing" in their domestic economies — and the U.S. Fed is raising short term rates — the U.S. term premium may continue to be low or negative.
When I checked a few of the countries, yields were similar after currency hedging, and generally it shouldn't be far off. So I don't know how much pricing pressure is actually from that. They're buying some bonds but what percentage of the market, anyway? I think term premia may be low across a number of countries, though if the US is likely to raise short-term rates more and faster, maybe lower in the US. Which if anything implies that the local bonds may be a better deal for the foreign investors, right, as least where the yield curves are not as flat.

Do you know of where to find stats on net change in ownership (who owns what) of Treasury bonds or other parts of the bond market?

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by SimpleGift » Sat Nov 18, 2017 3:50 pm

lack_ey wrote:
Sat Nov 18, 2017 3:18 pm
Do you know of where to find stats on net change in ownership (who owns what) of Treasury bonds or other parts of the bond market?
One can find monthly changes in foreign holdings of U.S. Treasuries here.

There looks to be both recent and historical data, broken down by individual foreign countries — but I haven't spent much time looking around at these data sets.
Cordially, Todd

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by lazyday » Sat Nov 18, 2017 4:38 pm

lack_ey wrote:
Mon Oct 23, 2017 8:01 pm
One of the more-cited models for the yield curve term structure these days, building on decades of work since the expectations hypothesis and other earlier ideas that are widely regarded as empirically untrue now, is from Adrian, Crump, and Moench (ACM) of the New York Fed. They have a post here with some details, a link to updated data, a link to a paper explaining the estimation methodology, and a comparison to some other models and estimates.
Is ACMTP02 the modeled term premium for a 2 year Treasury note?

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by lack_ey » Sat Nov 18, 2017 4:47 pm

lazyday wrote:
Sat Nov 18, 2017 4:38 pm
Is ACMTP02 the modeled term premium for a 2 year Treasury note?
Yeah, that's how it's structured. ACM model, TP term premium, 02 year Treasury. It's the top green line in the graph I posted.
SimpleGift wrote:
Sat Nov 18, 2017 3:50 pm
One can find monthly changes in foreign holdings of U.S. Treasuries here.

There looks to be both recent and historical data, broken down by individual foreign countries — but I haven't spent much time looking around at these data sets.
Great, thanks.

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by patrick013 » Sat Nov 18, 2017 9:23 pm

Well it's interesting how they went from OLS to a 5 factor
system. How they got the fitted line so close is beyond
me.
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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by Doc » Sun Nov 19, 2017 9:32 am

patrick013 wrote:
Sat Nov 18, 2017 9:23 pm
Well it's interesting how they went from OLS to a 5 factor
system. How they got the fitted line so close is beyond
me.
There was a saying in school about regressions.

Something like with one factor you can draw a line, with two you can draw a curve ... with four you can draw an elephant and with five you can make that elephant wag it's tail.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by in_reality » Sun Nov 19, 2017 10:21 am

lack_ey wrote:
Sat Nov 18, 2017 3:18 pm
SimpleGift wrote:
Sat Nov 18, 2017 2:56 pm
Isn't this a case of the U.S. Fed raising short term rates, but international investors piling into longer term Treasuries (driving their prices up and their yields down) — since their home country government bond yields are so low? This table shows the recent yields of longer term bonds in Europe, Japan and the U.S.:
In a world where there's relatively free movement of capital between countries, global bond investors are not just looking at U.S. reinvestment risk or inflation risk (though a consideration, for sure), but rather how the U.S. debt market compares with other developed country debt markets. Right now, U.S. Treasury yields are quite compelling.

If this is right, then as long as central banks in Europe and Japan are still "quantitatively easing" in their domestic economies — and the U.S. Fed is raising short term rates — the U.S. term premium may continue to be low or negative.
When I checked a few of the countries, yields were similar after currency hedging, and generally it shouldn't be far off. So I don't know how much pricing pressure is actually from that. They're buying some bonds but what percentage of the market, anyway? I think term premia may be low across a number of countries, though if the US is likely to raise short-term rates more and faster, maybe lower in the US. Which if anything implies that the local bonds may be a better deal for the foreign investors, right, as least where the yield curves are not as flat.

Do you know of where to find stats on net change in ownership (who owns what) of Treasury bonds or other parts of the bond market?
Why would foreign investors need to hedge though? Doing so will reduce their yields. Currency carry trading would have them leveraged and unhededged. And heck 10-1 leverage on hedged holdings in many cases is signifantly better than local rates.

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by garlandwhizzer » Sun Nov 19, 2017 11:21 am

It seems to me that the bottom line for investors is that at present you aren't getting paid much to take on duration risk in the bond market. The spreads between short term and long term bonds have been narrowing, just like the spreads between highest and lowest quality bonds. Add to this the expected loss of bond principal value in a rising rate environment which increases directly with duration. Taking on duration risk in the bond market has been well rewarded for 30+ years as both inflation and interest rates have relentlessly declined from historical highs (1982) to historical lows (excepting the Great Depression for inflation). This has given a consistent boost to returns from principal appreciation in longer duration bonds.

No one knows the future, but we may be at or near an inflection point where both inflation and interest rates begin to increase steadily and slowly for a long time, possibly decades. If that is the case, duration risk in the bond market may not be as well rewarded in the future as it was in the past. Likewise lower quality higher yielding bonds have done well in recent years as investors stretched for yield. Spread between high and low quality bonds are low by historical standards which means you aren't getting paid much to take on default risk either. Backtesting results in the bond market over the last 3+ decades is not IMO to be trusted as defining the future. This may be an opportune time to review your bond allocation if yield seeking in recent years has stretched you too far into duration or default risk.

Garland Whizzer

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by patrick013 » Sun Nov 19, 2017 2:37 pm

Doc wrote:
Sun Nov 19, 2017 9:32 am
patrick013 wrote:
Sat Nov 18, 2017 9:23 pm
Well it's interesting how they went from OLS to a 5 factor
system. How they got the fitted line so close is beyond
me.
There was a saying in school about regressions.

Something like with one factor you can draw a line, with two you can draw a curve ... with four you can draw an elephant and with five you can make that elephant wag it's tail.
The averages of the averages...but he's doing something else. Sticking small samples
together or using autocorrelation. Which does give me an idea about something else.
Still well beyond me.
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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by Doc » Sun Nov 19, 2017 3:51 pm

patrick013 wrote:
Sun Nov 19, 2017 2:37 pm
by patrick013 » Sun Nov 19, 2017 1:37 pm

Doc wrote: ↑Sun Nov 19, 2017 8:32 am
patrick013 wrote: ↑Sat Nov 18, 2017 8:23 pm
Well it's interesting how they went from OLS to a 5 factor
system. How they got the fitted line so close is beyond
me.
There was a saying in school about regressions.

Something like with one factor you can draw a line, with two you can draw a curve ... with four you can draw an elephant and with five you can make that elephant wag it's tail.
The averages of the averages...but he's doing something else. Sticking small samples
together or using autocorrelation. Which does give me an idea about something else.
Still well beyond me.
I found the five factor quote:
With four parameters I can fit an elephant, and with five I can make him wiggle his trunk.
Attributed to von Neumann by Enrico Fermi, as quoted by Freeman Dyson in "A meeting with Enrico Fermi" in Nature 427 (22 January 2004) p. 297
https://en.wikiquote.org/wiki/John_von_Neumann

This has little to do with where the term premia is or where it might go. It is just an comment on regression analysis beyond the limits of credulity.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by Doc » Sun Nov 19, 2017 4:08 pm

From The Only Guide to a Winning Bond Strategy You'll Ever Need, Larry E. Swedroe & Joseph H. Hempen p73
Fama and Bliss concluded that today’s yield curve contains information about future yield curves – current forward rates provide the best forecast of future spot interest rates. In other words, today’s yield curve is the best estimate we have of what future yield curves will be.
"But not a very good one." Swedroe again maybe from Bogleheads forum?

In any case I use today's yield curve for future projections without regard to risk, term or inflation premia as separate components.
A scientist looks for THE answer to a problem, an engineer looks for AN answer and lawyers ONLY have opinions. Investing is not a science.

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by lack_ey » Sun Nov 19, 2017 4:14 pm

patrick013 wrote:
Sun Nov 19, 2017 2:37 pm
The averages of the averages...but he's doing something else. Sticking small samples
together or using autocorrelation. Which does give me an idea about something else.
Still well beyond me.
There's a decomposition involved into uncorrelated principal components, which further increases the ability to span the data.

Apparently they build on a prior paper with four factors (and other similar research) to explain term structure and claim that the fifth is necessary.
Doc wrote:
Sun Nov 19, 2017 4:08 pm
From The Only Guide to a Winning Bond Strategy You'll Ever Need, Larry E. Swedroe & Joseph H. Hempen p73
Fama and Bliss concluded that today’s yield curve contains information about future yield curves – current forward rates provide the best forecast of future spot interest rates. In other words, today’s yield curve is the best estimate we have of what future yield curves will be.
"But not a very good one." Swedroe again maybe from Bogleheads forum?

In any case I use today's yield curve for future projections without regard to risk, term or inflation premia as separate components.
These papers are all past Fama-Bliss. It's no longer really thought that "today's yield curve is the best estimate of what future yield curves will be" which is kind of the stay-the-same hypothesis, implying a certain random walk. It's just that earlier ideas such as expectations hypothesis are empirically even worse.

That said none of the forecasting models are particularly good.
in_reality wrote:
Sun Nov 19, 2017 10:21 am
Why would foreign investors need to hedge though? Doing so will reduce their yields. Currency carry trading would have them leveraged and unhededged. And heck 10-1 leverage on hedged holdings in many cases is signifantly better than local rates.
That's fair enough, was just speculating on covered interest rate parity and then assuming uncovered may not be way far off that in terms of which investments are obviously better.

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by in_reality » Sun Nov 19, 2017 9:34 pm

lack_ey wrote:
Sun Nov 19, 2017 4:14 pm
in_reality wrote:
Sun Nov 19, 2017 10:21 am
Why would foreign investors need to hedge though? Doing so will reduce their yields. Currency carry trading would have them leveraged and unhededged. And heck 10-1 leverage on hedged holdings in many cases is signifantly better than local rates.
That's fair enough, was just speculating on covered interest rate parity and then assuming uncovered may not be way far off that in terms of which investments are obviously better.
Despite the theory, it seems that the expectation of UIP fails.

In a simple, risk neutral setting, uncovered interest parity (UIP) predicts that the currency of a
country with a high interest rate is expected to depreciate so that the profit is the same as from
investing in a low interest rate bond. Empirically, UIP fails and the expected profit from the carry
trade (investing in a high interest rate bond abroad, and then converting back to the home currency)
is positive.

http://www.lse.ac.uk/fmg/events/favilukisFGN.pdf


The carry trade, one of the oldest and most popular currency speculation strategies, is
motivated by the failure of uncovered interest parity (UIP) documented by Bilson (1981)
and Fama (1984).1 This strategy has received a great deal of attention in the academic
literature as researchers struggle to explain its apparent profitability

https://www.kellogg.northwestern.edu/fa ... /carry.pdf

Understanding the behaviour of currency markets has been an active area of research for the past few decades. Much of the literature has focused on the marginal behaviours of exchange rates and carry trade portfolio returns resulting from the established violations of uncovered interest rate parity. Such investment strategies are popular approaches which involve constructing portfolios by selling low interest rate currencies in order to buy high interest rate currencies, thus profiting from the interest rate differentials.

Our model is shown to provide superior risk-adjusted returns for a currency carry trade strategy over the period 1999 - 2014

http://ieeexplore.ieee.org/abstract/doc ... eload=true

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by lack_ey » Sun Nov 19, 2017 9:43 pm

Yeah, I know there's a lot of evidence and live trading results on currency carry, with UIP failing. I think that was the wrong point to make earlier, and mostly was just meaning to ask about relative Treasury flows to different holders.

My question is how much the yield differential is really worth given the uncovered currency exposure with the FX risk (investing in USD when you want some other currency). That seems like a relatively low Sharpe ratio trade for foreign investors, unless they also want to bet that FX movements will go their way. US rates aren't that much higher, and there's a decent chance there will be greater inflation in the US than in some of the low-yielding countries. How much pricing pressure are they really exerting on US bonds across the yield curve? Would the 10-year be at 4% were it not for foreign investors? 3%? Not even that much? What's actually the impact?

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by in_reality » Sun Nov 19, 2017 11:01 pm

lack_ey wrote:
Sun Nov 19, 2017 9:43 pm
How much pricing pressure are they really exerting on US bonds across the yield curve? Would the 10-year be at 4% were it not for foreign investors? 3%? Not even that much? What's actually the impact?
I'm not sure, nor am I sure that empirically it's known. This 7.2017 research suggests that for spot rates, it depends on the country and that for spot rates it's not relevant to the US.
These findings contradict the conventional view that sudden large movements in exchange rates are attributable to the carry trade. They suggest, instead, that the effects of the global carry trade are primarily concentrated in bond markets.
We believe that these interest-rate effects are due to the greater importance of carry trade
transactions in bond order flows. Future research using bond flows will determine whether
this conjecture is correct.
However, we do note that we could find no evidence of significant carry trade effects on the differential
between U.S. and E.U (Eurocurrency) interest rates. These are exactly the money markets where non-carry
factors driving order flows are likely to swamp the effects of the carry trade.
https://papers.ssrn.com/sol3/papers.cfm ... id=3057946

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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by patrick013 » Mon Nov 20, 2017 6:34 pm

lack_ey wrote:
Sun Nov 19, 2017 9:43 pm
How much pricing pressure are they really exerting on US bonds across the yield curve? Would the 10-year be at 4% were it not for foreign investors? 3%? Not even that much? What's actually the impact?
Foreign investors are buying about 22% of all TRSY sales. So it's in the trillions.
Certainly buying up the higher yielders across all maturities I suspect.
So it's interest rates or just plain imports using foreign currencies don't really
follow it, probably should.
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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by patrick013 » Tue Nov 21, 2017 3:26 pm

https://myphotos.mypclinuxos.com/images ... sed660.png

My little summary of spread history shows we're definitely not in the
better frequency of longer term premium observations. :)
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Re: Treasury term premium estimate: negative this year (NY Fed Adrian, Crump, Moench model)

Post by BlueEars » Tue Nov 21, 2017 9:51 pm

Speaking of the Treasury term premium, I recently took the Simba data and looked at how the short term Treasuries did versus the intermediate Treasuries in the 1950's through the early 1970's. Seems that the short term Treasuries returned more then the intermediates more often then not as rates rose erratically.

In this chart I took the 5 year rolling returns for each bond type. Then subtracted the returns to plot the 5 year rolling return differentials i.e. intermediate Treasury rolling return minus short term Treasury rolling return:

Image

and here is how the 5yr constant maturity Treasury behaved during those decades: https://fred.stlouisfed.org/series/GS5
I could not seem to post the image now, so this URL will have to do.
.

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