With interest rates rising we are seeing an old term recycled by the popular press – the Bond Vigilante. But who are these vigilantes and what are they doing?
The bond vigilante is a mythical beast with superpowers according to many, but essentially it refers to investors making up the bond market. The name was coined by Dr. Ed Yardeni, a market forecaster and longtime consultant to CCM, back in the 90’s when the Federal government was running substantial budget deficits which had negative impacts on the bond market and interest rate levels. James Carville, Bill Clinton’s political advisor once famously said “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
The term bond vigilante gained popularity during that period because federal politicians became acutely attuned to fiscal and monetary policy and the linkage to bond market performance, the thought being that these faceless investors – the vigilantes – were driving policy decisions. There is no question that there was a connection as investors were deeply concerned about the budget deficit and its impact on interest rates. In fact, this linkage was a factor in Federal budget planning which ultimately led to the last budget surplus produced by the United States. Bond vigilantes conjure up an image of a cabal of investors who have decided to move the market in a direction, but the bond market is simply where investors buy and sell bonds, pursuing their various investment themes. The fact that bond investors tend to be attracted to fiscal and monetary policies that promote price stability is unsurprising as such policies are friendly to fixed income investments such as bonds.
After the turn of the new millennium, especially after the Great Financial Crisis (GFC) when monetary authorities were hyper-focused on preventing deflation, investors became less concerned with the inflation implications of easy monetary and fiscal policy. And with good reason – despite fiscal and monetary stimulus never seen before in the history of the United States, inflation remained remarkably low. Many theories have been advanced as to why, but, inflation remained bottled up for whatever reason. That is, until the COVID pandemic and the Ukraine invasion.
Both of these events triggered supply shocks that led to supply/demand disruptions which had very predictable results in the form of higher prices. With that jolt of inflation, attention turned to the expansionary fiscal and monetary policies and the inflation implications. Bond investors – the bond vigilantes – began demanding higher rates to induce them to buy securities because they were concerned about the corrosive effects of inflation on their investments. This further led to a renewed focus on those expansionary policies which have inflation implications. Thus, the bond vigilantes became a force again.
The most dramatic example of this re-emergence is the fiscal crisis in the UK that cost the Chancellor of the Exchequer his job and will likely cost Prime Minister Liz Truss her post. Bond investors (the bond vigilantes) rebelled upon learning of the Truss plan to cut taxes and create subsidies to offset high energy prices – actions that would clearly increase the UK deficit in the midst of a slumping economy. Investors became concerned over the creditworthiness of British bonds. Yields skyrocketed creating havoc in the UK private pension system requiring an abrupt about face on the part of the Truss government.
One interesting takeaway from the UK crisis as well as other foreign debt crises and our current brush in the US with the bond vigilantes is that it is difficult to know when bond investors will rebel and act in a herd fashion. Seemingly there is a triggering event such as supply chain shocks that focuses attention. But in the end evaluation, loose fiscal and monetary policy works…until it doesn’t.