The term “bond vigilantes” was coined sometime in the 1980s as a clever way of describing how bond market investors and traders tend to push bond prices lower and yields higher in response to overly profligate government deficit spending or overly stimulative monetary policy. If market participants sensed that monetary or fiscal policies were becoming too liberal, they would quickly decide that the risk of higher inflation had increased and, therefore, they would sell longer-duration notes and bonds. The consequent higher yields on those issues would, in theory, offset the stimulative effects of the inappropriate government or Federal Reserve (Fed) policies. President Clinton was famously quoted as saying he would like to someday become a bond trader so he could be one of the most powerful persons on the planet. Indeed, one of the reasons given for raising taxes during his term in office was that the consequent reductions in the federal deficit would bring down bond yields, and the net result would be stronger economic growth.
It would be hard to envision a more profligate pace of federal spending or more stimulative monetary policies than those currently in place. Indeed, federal deficits are so large that one major credit rating agency cut the rating of U.S. bonds to AA from AAA. Moreover, inflation has been accelerating. The year-over-year increase in the Consumer Price Index increased from 1.2% last July to 3.6% now. Yet yields in Treasury notes and bonds have been falling, to some of the lowest yields on record. In the first trading day after the ratings downgrade was announced, prices of Treasuries rose sharply. Where are the bond vigilantes now? Have they been anesthetized or are they merely asleep?
Fed tightening is the likely target of bond vigilantes
The answer, in part, might be that if they existed in the first place, the vigilantes were misunderstood. They were not responding to fears of inflation or Treasury deficits, but were most afraid of Fed tightening. A rising fed funds rate, or expectations of that policy shift, often results in a selloff in notes and bonds. Bond traders learn early in their careers not to fight the Fed. (If they don’t learn that, they don’t last long enough to have a career.) This helps explain why Treasury bonds could rally so strongly in August. Weaker economic indicators, sharp declines in stock prices plus the turmoil in Europe convinced many market participants that the Fed would very likely keep the fed funds rate near zero longer than they had been expecting. Then, on August 9, the Fed’s Open market Committee announced that they expected the funds rate to stay this low for at least another two years. That set off another wave of buying of Treasury bonds. The market is apparently more vigilant toward the outlook for the fed funds rate than toward the outlook for inflation or the outlook for Treasury deficits. And now, the Fed has all but promised that market participants need not worry about a rising funds rate.
To be sure, vigilantes are not always the dominant bond market participants. Recently, international fund managers seeking a safe haven have been apparently fleeing the European markets in favor of Treasuries. The safety bid for Treasuries has been a big factor pushing yields to all-time lows. If that bid were to weaken, Treasury yields could rise somewhat even if the vigilantes are quiescent. That is what happened last year. From February through June, when the eurozone crisis was unfolding, foreign purchases of Treasuries were very strong. The yield on the 10-year Treasury fell from 4% in April to 2 ½% in August. As the euro recovered in the fall, foreign purchases of Treasuries fell to one-half the first-half pace, and Treasury yields began to increase. By year end, the 10-year yield was back above 3%.
Bond investors should watch the economy, not the Fed
As usual, economic indicators released in the weeks and months ahead will have a big influence on the direction of bond yields. They will be more important than pronouncements from the Fed. Such indicators as the Institute for Supply Management indices, the consumer confidence indices, and measures of consumer spending will determine whether the economy is experiencing a double-dip recession. With this latest rally, the Treasury market has apparently priced in expectations of a recession in 2011 or 2012. If these data were to improve enough to change those expectations, these exceptionally low yields might quickly become untenable. Any subsequent rise in yields might again be attributed to the bond vigilantes reasserting their influence. A less colorful, but perhaps more accurate, explanation would be that in the absence of recession signals, traders could no longer expect to make capital gains owning longer- duration notes and bonds. In their attempt to lighten positions, they helped push yields to more sustainable levels.
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