The Increasing US Deficit Triggers Concern Among Bond Vigilantes

The Rise of Bond Vigilantes: How They Impact Markets and Policy


When interest rates were near zero and the Federal Reserve was buying tens of billions of dollars’ worth of Treasury bonds every week, the prospect of ballooning US budget deficits seemed manageable. However, with the official interest rate soaring past 5%, the price of the benchmark 10-year Treasury bond tumbled, driving its yield to the highest in 16 years. Experts say these forces are empowering so-called bond vigilantes — the banks, hedge funds, and insurers that seek to enforce fiscal discipline by driving up government borrowing costs.

What are Bond Vigilantes?

The phrase “bond vigilantes” was coined in the early 1980s by economist Ed Yardeni. In a July 1983 paper, he wrote, “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit market.” The 10-year Treasury yield was 11.5% when he made his comments; within a year, it had climbed to almost 14%.

The Role of Bond Vigilantes

When a government is in danger of mismanaging its economy and undermining its creditworthiness, fixed-income investors can call what amounts to a buyers’ strike. The resulting jump in bond yields helps tame spending ambitions by making government borrowing more costly, in turn averting a rise in inflation that would erode the value of future debt interest and principal payments.

Bond Vigilantes’ Impact on Markets and Policy

Bond vigilantes have historically affected markets and policy. In the early 1990s, bond vigilantes in Sweden compelled the government to reduce its deficit by pledging not to buy Swedish bonds. This led to a surge in bond yields and forced the government to slash spending. Bond vigilantes also influenced President Bill Clinton to focus on deficit reduction rather than his ambitious domestic agenda. The impact of the bond selloff on the politics of the time was significant.

Measuring the Influence of Bond Vigilantes

While there isn’t a precise way to quantify the impact of bond vigilantes, the term premium can serve as a proxy. The term premium measures the extra yields investors demand to hold longer-term bonds. When the premium increases, it means investors are more worried about the long-term sustainability of US fiscal policy and demand more compensation. A model developed by the New York Fed shows the term premium on 10-year Treasuries steadily increasing since the US credit ratings downgrade in 2023.

The Return of Bond Vigilantes

“The bond vigilantes are back,” wrote Yardeni in the Financial Times. The stimulus programs introduced to alleviate the economic aftershocks of the pandemic have stoked inflation, leading central banks to raise interest rates. The US Treasury is now paying elevated interest rates on its debts, making investors nervous. However, with a US election looming, it remains uncertain whether the government will rein in its spending plans.

The Future of Bond Vigilantes

The 10-year Treasury yield is currently about 4.6%, double the average for the past decade. Economists predict that US inflation will slow down in the coming years. If the economy slides into a recession, consumer prices may ease at an even faster pace, allowing the Fed to reduce official rates and bond yields to subside.

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Read More of this Story at – 2023-10-13 13:05:00

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