Pacific Investment Management Co. is warning that US fiscal profligacy threatens to drag the Treasury market back to 1980s, a time when bond vigilantes demanded far higher compensation to own longer-dated bonds.

A combination of stickier inflation and deteriorating budget estimates “could start to reverse the 40-year downtrend” of a key measure of how much bond investors are compensated for holding long-term debt, according to Marc Seidner, chief investment officer of non-traditional strategies, and Pramol Dhawan, portfolio manager at Pimco.

“What if we are heading back to the future, to a market resembling prior decades when higher term premiums prevailed?” they asked in a paper published Thursday. Term premium is generally described as the extra yield investors seek to own longer-term debt instead of rolling over into shorter-term securities as they mature. It’s viewed as protection for bond holders against unforeseen risks such as inflation and supply-demand shocks, beyond other drivers of Treasury yields including economic growth and Federal Reserve policy.

Since the global financial crisis, a New York Federal Reserve model of term premia on the 10-year has averaged less than 0.5% and spent considerable time below zero. Last September, this measure briefly turned positive as the 10-year yield shot higher and peaked above 5% the following month amid concerns about US deficits, and the prospect of higher-for-longer Fed policy rates.

While term premium remains slightly negative, bond investors are wary of another climb that in turn could push 10-year yields back toward 5% and spark broader financial market tumult.

“If the term premium returned even to levels common in the late 1990s to early 2000s – around 200 bps – that would likely become the defining feature of financial markets during this era,” the California-based money manager cautioned, adding such an outcome “would not only affect bond prices, but also prices of equities, real estate, and any other asset that is valued based on discounted future cash flows.”

Treasury Market Term Premium Slumbers | New York Fed Model has been sliding since the 1980's
Fitch’s downgrade of the US credit rating last year focused investor attention on rising spending in Washington. “More deficits are in the cards,” Pimco warned, and “the important point is that markets are a disciplining mechanism for governments, keeping them from straying too far down this spending path.”

Among the main investment implications of a rising term premium, is a steeper yield curve the asset manager argued.

Currently, the 10-year sits around 4.25%, below those of shorter maturities and the Fed’s target rate of 5.25% to 5.5%. This curve inversion usually corrects once the central bank eases policy, but Pimco doesn’t rule out “the possibility of a much bigger shift ahead: that the curve will also correct as the term premium comes back.”

“There is a very real possibility that the curve could kink following the first Fed rate cut, with shorter-term yields declining, intermediate rates not moving much, and longer-term yields rising as the term premium stages a comeback,” the firm concluded. 

This article was provided by Bloomberg News.