How the Market Prices Debt Crises: Insights from Rising Term Premiums on the U.S. Economic Outlook

This week, the cryptocurrency market experienced significant fluctuations, and the price trend showed an M-shaped pattern. This indicates that as Trump's inauguration date approaches, the capital market has begun to assess the opportunities and risks following his election, marking the end of a three-month sentiment-driven market. Currently, it is necessary to extract the short-term gaming focus from the myriad of information in order to make rational judgments about market changes.

Overall, the prices of high-growth risk assets, including the cryptocurrency market, are likely to remain under pressure in the short term. This is due to the widening term premium in the U.S. Treasury market and rising medium to long-term interest rates, which have an adverse impact on these assets. The root of this situation lies in the market pricing in a potential debt crisis in the United States.

Macroeconomic indicators remain strong, and inflation expectations have not significantly worsened.

To analyze the factors behind the short-term price weakness, let’s first look at several important macroeconomic indicators. In terms of data related to U.S. economic growth, both the ISM Manufacturing and Non-Manufacturing Purchasing Managers' Indexes have been consistently rising. Since the Purchasing Managers' Index is usually a leading indicator of economic growth, this suggests a relatively optimistic outlook for the U.S. economy in the short term.

In terms of the job market, non-farm payroll data increased from 212,000 last month to 256,000, far exceeding expectations. At the same time, the unemployment rate fell from 4.2% to 4.1%. JOLTS job vacancies surged to 809,000. The number of initial unemployment claims continues to decline, indicating a positive outlook for the job market in January. All these data suggest that the current U.S. job market remains strong, with a higher likelihood of a soft landing for the economy.

In terms of inflation, the University of Michigan's 1-year inflation expectations in the U.S. have slightly risen to 2.8%, but remain within a reasonable range. From the changes in the yield of inflation-protected securities (TIPS), it seems that the market is not overly concerned about inflation.

In summary, from a macro perspective, there are no obvious problems in the U.S. economy. Next, we will explore the core reasons that have led to the decline in the market value of high-growth companies.

US Treasury long-term interest rates continue to rise, and term premiums are increasing.

The U.S. Treasury yield curve shows that long-term rates continued to rise over the past week. Taking the 10-year Treasury as an example, the increase exceeded 20 basis points, further exacerbating the bear steepening pattern. The rise in Treasury yields typically has a more negative impact on high-growth stocks than on blue-chip or value stocks, primarily due to the following reasons:

1. Rising financing costs affect business expansion.
2. The increase in the discount rate for future cash flows lowers the valuation of the company.
3. Investors may turn to more robust value stocks
4. Companies may reduce research and development and expansion expenditures.

In contrast, stable companies are relatively less affected because they typically have strong profitability, stable cash flow, and lower reliance on external financing.

The rise in long-term government bond yields has a particularly noticeable impact on the market value of technology companies such as cryptocurrencies. So, in the context of interest rate cuts, what is the core reason for the rise in long-term government bond yields?

The market is pricing in a potential debt crisis

The nominal interest rate calculation model for government bonds is: I = r + π + RP

In this context, I represents the nominal interest rate of government bonds, r is the real interest rate, π is the inflation expectation, and RP is the term premium. The real interest rate reflects the true return on bonds and is not influenced by market risk appetite. Inflation expectations are typically observed through CPI or TIPS yields. The term premium reflects the compensation required by investors for interest rate risk.

The previous analysis indicates that the U.S. economy is developing steadily in the short term, and inflation expectations have not risen significantly. Therefore, real interest rates and inflation expectations are not the main factors driving the increase in nominal interest rates. The focus is on the term premium.

Observing the estimated term premium level of U.S. Treasuries from the ACM model, the term premium of the 10-year Treasury bond has significantly increased, which is the main factor driving the rise in U.S. Treasury yields. On the other hand, the recent changes in the Merrill Lynch U.S. Treasury option volatility (MOVE index) have been minor, indicating that the market is not sensitive to risks of short-term interest rate fluctuations and has not made significant risk pricing for potential policy changes by the Federal Reserve.

The continued rise in term premiums indicates that the market is concerned about the medium- to long-term development of the U.S. economy, primarily focusing on the issue of fiscal deficits. Therefore, it can be confirmed that the market is currently pricing in the potential debt crisis risk for the U.S. after Trump's inauguration.

In the near future, paying attention to the impact of political information and stakeholders' viewpoints on debt risk will help in assessing the trends in the risk asset market. For example, Trump's announcement of considering a national economic emergency in the U.S. may amplify concerns regarding the impact of the trade war, but the increase in tariff revenue has a positive effect on U.S. fiscal income, so the impact may not be particularly severe. In contrast, the progress of tax reduction legislation and how to cut government spending are the key points that deserve the most attention in the entire game.