Pacific Investment Management Co. (Pimco) is sounding the alarm on the swelling US fiscal deficit, cautioning that it could lead to a resurgence of higher bond yields reminiscent of the 1980s. Marc Seidner, Pimco’s chief investment officer of non-traditional strategies, and Pramol Dhawan, portfolio manager, highlight the potential reversal of a four-decade downtrend in a key measure of bond investor compensation.
In a paper published Thursday, Seidner and Dhawan raise the question of whether the market is heading “back to the future,” resembling past decades when higher term premiums prevailed. Term premium, the additional yield investors demand for holding longer-term debt, is seen as a safeguard against risks such as inflation and supply-demand shocks.
Since the global financial crisis, the term premium on the 10-year Treasury has averaged less than 0.5% and often dipped below zero. However, last September, concerns over US deficits and the possibility of sustained Fed policy rates prompted a brief positive term premium as the 10-year yield spiked above 5%.
While the term premium remains slightly negative, investors are wary of a potential climb that could push 10-year yields back toward 5%, potentially triggering broader financial market turbulence. Pimco warns that if the term premium returns to levels seen in the late 1990s and early 2000s, around 200 basis points, it could significantly impact various asset prices beyond bonds, including equities and real estate.
Fitch’s downgrade of the US credit rating last year highlighted the rising spending in Washington, drawing investor attention to the growing deficits. Pimco emphasizes the role of markets as a mechanism for disciplining governments against excessive spending.
One of the main investment implications of a rising term premium, according to Pimco, is a steeper yield curve. Currently, the 10-year yield sits around 4.25%, below shorter maturities and the Fed’s target rate. Pimco suggests the possibility of a significant yield curve correction as the term premium rebounds, potentially leading to a scenario where shorter-term yields decline while longer-term yields rise.
In conclusion, Pimco’s warning underscores the potential impact of fiscal deficits on bond yields and broader financial markets, emphasizing the need for vigilance and proactive risk management strategies.
