Are the bond vigilantes back?

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The rise and fall of the bond market vigilantes

The heyday of the bond market vigilantes was during the Clinton presidency (1993-2001). During that period both Treasury Secretary Ruben and Fed Chair Greenspan argued that budget deficits created so much pressure on bond yields that reducing the deficit might actually stimulate the economy. This argument seemed a bit overdone to me, but it reflected the reality of bond market dynamics at the time.

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Over the decades, bond vigilantes have been beaten into submission like the moles in a game of wack-a-mole. Coming out of the 1965-80 Great Inflation bond yields were very high as investors demanded a large inflation risk premium. This could be seen in both market pricing and in surveys of household inflation expectations (chart). However, as the Fed continued to chip away at inflation and committed fully to a 2% target, inflation expectations and the inflation risk premium dropped. Indeed, prior to the Pandemic inflation expectations were starting to settle to below the Fed’s 2% target.

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Other developments reinforced the downward trend in bond yields particularly in the last two decades. First, interest rates have been even lower in other developed market economies, including near-zero yields in Japan. Second, the 2007-9 Great Financial Crisis was followed by a long “rehab recovery.” Even with near-zero policy rates and bond buying programs by the major central banks it took a long time for the US and global economy to recover. Yields finally hit bottom in 2020 when COVID crushed the economy and briefly caused a further drop in inflation.

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What, me worry?

The upshot was that a generation of investors has learned that it is dangerous to short the bond market. With brief interruptions, bond yields fell from a peak of about 16% in 1981 to below 1% in 2020 (chart). I think this seemingly relentless trend is a big reason the markets have become oblivious to the budget outlook.

The bond market has been repeatedly stress tested.? Each time it weathers a threat, the downward trend in yields looks more inexorable. Consider the challenges:

·????? The major central banks adopted bond-buying programs that look dangerously close to debt monetization. However, with inflation persistently low, investors accept the idea that the programs will reverse if inflation emerges.

·????? Japanese debt exploded into new territory, but Japanese bond yields refuse to budge. If Japan can do it, why not the US?

·????? Congress has repeatedly shut the government down and threatened to default on the debt. The result: small, episodic pressure on yields.

·????? The Republican party shifted from focusing on deficit discipline to focusing on deficit-financed tax cuts. Trumps tax cut (and spending increase) in 2017 produced the biggest deficit in US history outside of a recession or major war (chart). Meanwhile, for Democrats it seems increasingly that the sky is the limit on deficit-financed spending. The US fiscal response to COVID was several times bigger than for other advanced economies.

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Rip Van 10-year

In recent decades, one of the most common questions I’ve gotten from clients is: if the bond market can sleep through all of that, what will it take to wake it up? A corollary question is: when will the dollar lose its reserve currency status? My answer has always been a bit of a dodge: There is no obvious alternative to the dollar and US treasury market as the center of global capital markets. Hence, I don’t really know when the disaster will happen, but not soon.

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I’m not brave enough to say the day of reckoning is now, but certainly the alarm bells are blaring. The budget deficit is already out of control (see chart above).? In the good old days that would have forced the two political parties to propose plans for fixing the problem. In this election the opposite is happening: both candidates are proposing policies that would push the deficit even higher.

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Harris is promising to expand the deficit with a number of new spending increases and tax cuts. Her promise to raise taxes on the most wealthy Americans and corporations doesn’t come close to paying for this stuff.

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However, compared to Trump, Harris is a staunch fiscal conservative. Trump seems to offer a new tax break every couple weeks. A number of studies have correctly concluded that his policies would create even bigger deficits, and be even more inflationary, than Harris’s.

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Beyond the budget, investors are not paying enough attention to another existential threat to the dollar and the bond market: Trump’s push to take away the independence of the Federal Reserve.

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History is loaded with examples of what happens next. When the next bout of inflation arrives they central bank will refuse to hike. And when elections loom, the bank will ease to goose up growth and help the incumbent party, knowing that inflation will come with a lag.

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Of course, campaign promises are made to be broken. In many cases they also depend on having the support of Congress. For example, perhaps the easiest way to undermine Fed independence would be to appoint governors that are politically pliable as openings arise. However, that would require that the Senate go along. In Trump’s first term, even with a Republican majority in the Senate, they rejected some bad candidates and supported good candidates. Will the new Senate defend the Fed or capitulate to pressure?

Direction of travel clear; timing uncertain

Like most economists, I’m not comfortable making short term market calls. The fundamental policy and economic backdrop matters in the medium term but can be easily overwhelmed by other market drivers in the near term. However, I think there is a good fundamental case for bond yields trending higher. Four things stand out:

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·????? The 10-year yield has been on a choppy upward climb for more than four years now, marking the longest “bond bear market” since the 1970s. Could investors decide rising yields is more of the norm than the exception?

·????? As discussed above, not only are policy proposals pointing to higher bond yields, but I think investors are beginning to care. Look out if one party sweeps and is able to enact a lot of its campaign proposals.

·????? I still think the market is underpricing the neutral funds rate. The consensus seems to have shifted up from about 2.5% to about 3%, but I still think 4% makes more sense. A good starting point for thinking about the neutral rate is that it should be correlated with the 4% or so trend growth in nominal GDP (Chart above). More important, market and economic resilience suggests that current Fed policy is not nearly as tight as the consensus and Fed believe.

·????? While the Fed is winning the war on inflation, there are likely some more lasting effects. Inflation expectations seem to have risen from below-target to slightly-above-target. And nominal wage growth could remain high as workers demand payback for a period of weak real wages.

Even Rip Van Wrinkle woke up after 20 years.

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