Don’t Discount Bond Vigilantes, Says Economist Who Named Them

(Bloomberg Businessweek) -- The once-feared bond vigilantes have been quiet lately.  In Wall Street lore, they’re the investors who take matters into their own hands when the government isn’t protecting the currency. If inflation rises, deficits grow, or a country’s creditworthiness is at risk, the bond vigilantes sell bonds en masse, pushing up interest rates sharply and forcing the government to get serious.

The vigilantes were nowhere to be seen on June 9, a day when interest rates went down instead of up. The yield on the 10-year Treasury note fell to 1.48% after having gotten as high as 1.74% at the end of March. That was in spite of economists’ predictions that on June 10, the Bureau of Labor Statistics would report that consumer prices rose 4.7% in the year through May. 

Edward Harrison went so far as to write a June 9 article, “The Death of the U.S. Treasury Bond Vigilante,” for the Credit Writedowns newsletter, which he founded. “The bond markets aren’t intimidating anyone right now,” he wrote. 

Are the vigilantes really pushing up daisies? I put that question to economist Edward Yardeni, president of Yardeni Research Inc., who coined the term “bond vigilante” in 1983, when they were a force to be reckoned with. His short answer was no.  His long answer was full of the kind of strong opinions you’d expect from a guy who’s been following the markets since receiving his doctorate in economics from Yale in 1976.

Here’s a condensed version of what he said:

Their heyday was in the 1980s when we had four episodes where bond yields went up and subsequently nominal GDP went down. … As has been widely known, the Clinton administration feared the bond vigilantes. As a result it maintained a fair amount of fiscal discipline. We actually ran surpluses.

Meanwhile along the way some very powerful anti-inflationary forces came into play. The need for them to be vigilant dissipated in 1990s through 2000s. Then we had the global financial crisis, a big increase in the deficit. They still remained quiet.

The vigilantes rose up in Greece. In 2010-11 the sovereign bond yield rose to 40%. Draghi [former European Central Bank President Mario Draghi] calmed them down. 

Coming out of 2008, the central banks adopted unconventional monetary policy. They increased balance sheets. The bond market was no longer a market. The supply and demand for bonds was no longer being determined by free-market forces. Central banks, some would say, were rigging the bond market.

Even if the vigilantes wanted to express an opinion, they were stymied by the actions of the central bank. Then again, there wasn’t much to complain about.

The vigilantes may very well have come back from the dead starting last August. The Fed was buying all these notes and bonds, but the 10-year yield popped up to 1.7% earlier this year. Arguably somebody was selling while the Fed was doing all this buying, and they had enough clout to push the bond yield up. It had to be private investors.

In March, MMT [Modern Monetary Theory, which is relaxed about budget deficits] was embraced by the Fed and the Treasury. You might as well put them in the same building and consolidate their statements.

I asked him if the vigilantes are dead.

I don’t think they’re dead. Let’s see what happens tomorrow [with the inflation report]. Anecdotally my 22-year-old son walked into my home office. He just got a haircut. He said they raised the price from $20 to $26. When the barbers start raising prices, you have to worry about broad-based inflation.

I’m sticking with my call of 2% [yield on 10-year Treasury notes] by yearend. Inflation is going to be a little bit longer-lasting than the markets are anticipating.

It’s not as easy being a bond market vigilante now as it was in the 1980s. Then, the Fed didn’t intervene directly in the bond market. Give them even more credit for a valiant attempt to express an opinion when they’ve been gagged for so long by the central bank.

In a free, competitive market, the price mechanism works. But this is not a free market.

The longer the Fed keeps buying bonds, the more [potentially] powerful the bond market vigilantes are going to get because the compounding effect of higher rates on debt-service payments would be just a killer. We got a glimpse of that in 2017-18 when rates were going up.

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