OK

Okay, admittedly, the title is purposely provocative. Depending on how you define “bond vigilante”, and what government bond market you're talking about, they actually very much do exist. But the way many people are defining them with respect to the United States, they really never did exist. So talk of a return of the bond vigilantes because of a brief increase in 10-year yields above 2% is a bit hysterical, to say the least.

Participants in the US Treasuries market care about one thing: inflation. For non-US national economies that do not have a sovereign unpegged currency, this concern may include risk of repayment (like Greece, Spain, Argentina). But for the US Treasury market, have no fear, because there never really have been any bond vigilantes to "punish" the US for running large deficits, just rational participants responding to growth and inflation expectations (expected inflation -> sell bonds, resulting in higher market yields).

In general, government bonds serve the purpose of providing a safe, guaranteed stream of income in a currency, and have historically been used by investors as the bare compensation to catch up with inflation. In times of higher inflation, investors demand higher returns on Treasuries (and the Fed accommodates this by fighting higher inflation with higher short-term rates, to entice investors to park their money to cool down growth). In times of lower inflation, Treasuries have a very low return, reflecting slow growth, and consequently, very little price pressure (which the Fed also accommodates with lower short-term rates that push investors out of the unattractive safe returns into other assets).

Defining the Bond Vigilante

To start, this discussion is nothing new, and it's picking up steam from the likes of Cullen Roche at Pragmatic Capitalism as well as Matthew Yglesias at Slate. But I just wanted to expound on this by analyzing the time period where the term “bond vigilante” really solidified its place in the financial press' lexicon, and even in the vernacular.

Let's establish a basic definition. Most people would look at Wikipedia perhaps as a valid authority on this, which defines the term as:

“A bond vigilante is a bond market investor who protests monetary or fiscal policies they consider inflationary by selling bonds, thus increasing yields”

Protests? Don't traders trade to...well, make money, right? Not to make political statements...

But, this isn't as bad of a definition or discussion about bond vigilantes as you'll find, for example, at the metal-crazy Austrian (Austerian?) sites talking about default risk in the United States:

“The bankers’ credit fueled a 300-year global expansion which transformed the world. The bankers’ credit, however, has now become debt which increasingly cannot be repaid….”
Cannot be repaid! Wow, well we know that's not true, there's no risk of repayment for a monetary sovereign, but there's still the risk of inflation.

So we're getting closer to a definition that works more generally, let's settle on this one from “Invesco Perpetual”:

“Investors in bonds who pay particular attention to policies that could be deemed to be inflationary or increase default risk. Inflation erodes the value of capital and interest payments on bonds, since these tend to be fixed. Therefore, higher inflation will tend to push bond prices lower.”
Now we're getting somewhere. This definition is worldwide, as there are certain nations that are in fact constrained in their production of the national currency, either because of a peg in the case of numerous economies in Latin America and Asia, or because of simply adopting an entirely different currency as their own, such as Ecuador or Greece. In reality, these are just participants in the bond market that are rationally managing their portfolios in response to alternative incentives, not punishing politicians for debt levels per se.

Are there really American Bond Vigilantes?

In the United States, there is no default risk, save for incredibly stupid politicians who don't quite understand the monetary system.  But going back to the Wikipedia definition, this is the kind of thing that is driving the misunderstanding behind what “bond vigilantes” do. They're not “protesting” possible inflation, they're merely rational market participants who are analyzing monetary and fiscal policy, as well as social trends, to guage the risk of inflation, and inflation occurs in the face of growth.

If there is expected future growth, why would anyone want to hold on to government bonds that give traditionally lower, yet safer returns. There would clearly be better opportunities in private bonds, or private equities, or just general economic projects that would have higher yields. So this has nothing to do with “protests” to chastise policymakers over high spending that could fuel inflation, and absolutely nothing to do with high spending that would lead to an unsustainable debt burden that would fuel default risk as a possibility. Instead, they are merely market analysts who are chasing yields.

Potential growth, leading to potential inflation, leading to better yields in non-bond markets, are what lead investors to sell Treasuries to invest in other projects. Additionally, the Federal Reserve controls the short-term rates on debt, and if they don't see the inflation, and don't raise rates to attempt to counter inflation, then the bond markets tend not to react. In this sense, markets follow the Fed's lead, which follows the data that comes out, which is all about one thing: inflation. The Fed will not raise rates (or theoretically should not) unless there is a risk of inflation that requires a "cooling down" of growth.

The market participants understand this, but the American people don't. The root of this problem is bad journalism, and thus inadequate informing of the public.

Case in point is when so-called journalists like Robert J. Samuelson (who unfortunately shares the surname of one of the greatest economists in history) push bad analysis of bond markets and fiscal policy, such as this:

"I was arguing that today’s highly indebted governments have less leeway to adopt massive 'Keynesian' stimulus programs of spending increases or tax cuts without triggering a backlash from bond markets — higher interest rates that undermine the stimulus. I still believe that’s true; the evidence is Greece, Ireland, Portugal, Spain and Italy."
So we have American journalists telling Americans that they are like nations that don't have their own currency, and thus hysteria over debt levels, despite a calm bond market, is warranted as if we were Greece (and it's worth noting every example he used was a Eurozone nation trapped in a currency they had no real control over). And we're told that the bond market vigilantes that have rightfully sold off peripheral Eurozone debt, leading to higher yields, are the same creatures that will attack the United States' bond market, despite a fiat currency without any hard constraints. This is wrong, so very wrong.

But in American history since the removal of the gold peg, do we really see any true acts of “bond vigilantism”? Are market participants historically really chastising policymakers for deficits and risks of inflation that don't materialize? Do they really sell off bonds in protest, without having a different opportunity that gives them motivation to sell?

Click below for an analysis of the supposed bond vigilantes in the Clinton era, where I point out that not only were the economists at the time (and still today) confused and downright wrong about what drove the Treasury market during that time, but they infected the psyche of people ever since then to misunderstand the phenomenon as one driven by debt load, not inflation risk.

Analysis of Clinton-era So-called Attack of the Bond Vigilantes

Digging into the history of the use of this term, it seems to be mentioned retroactively to refer to the high Treasury rates of the 70's and 80's. But this was a time of actual inflation, driven by a supply shock of a key input (oil). The bond market reflected that inflation, the inflation didn't come about because of the yields in the Treasury market.

However, the term really came into public use during the Clinton years in late 1993, when 10-year Treasury yields jumped. We get interesting explanations as to why this occurred, but to get the prevailing “wisdom of the market” regarding this issue, here's what Ronald McKinnon in an op/ed piece for the Wall Street Journal wrote:

“For example, in 1993 when the Clinton administration introduced new legislation to greatly expand health care without properly funding it ("HillaryCare"), long-term interest rates began to rise. The 10-year rate on U.S. Treasury bonds touched 8% in 1994. The consequent threat of a credit crunch in the business sector, and higher mortgage rates for prospective home buyers, generated enough political opposition so that the Clinton administration stopped trying to get HillaryCare through the Congress.”
Let that sink in for a minute. It seems unfunded bills for spending were seen to be the main motivation for the selloff, according to what is supposed to be a credible economist from Stanford, Ronald McKinnon.

I thought that was a bit of an odd claim. Considering that by memory I knew that inflation wasn't a major concern back then, and the idea that proposed legislation would spur inflation risks seemed odd and rather unfounded.  So I dug into the general macroeconomic data in the surrounding years:

10-year Treasury yields and Effective Federal Funds Rate

Figure 1: 10-year Treasury yields and Effective Federal Funds Rate

In Figure 1 above, we can see the true ascent of the 10-year yields began basically in the beginning of 1994, well after the legislation was proposed by Clinton in 1993. It's also well-known just how unlikely this legislation was at the time, the famous “Harry and Louise” commercial had done its job to propagandize Americans into thinking this was just a bad idea to cover everyone's for healthcare services. In other words, this was not a credible threat to high spending which would fuel inflation, or high spending that would fuel “unsustainable debts.”

Even well after the bill was declared dead by Senate Majority Leader George in mid-1994, the 10-year Treasury yields continued to climb into 1995. Clearly we can determine that the legislation regarding Hillarycare was not really the driver of rates, despite the claims of a supposedly esteemed academic economist. On the contrary, in Figure 1 you can also see that the increase in the Federal Reserve's federal funds rate preceded the increase in yields in the 10-year Treasury (which was flat through the end of 1993 and early 1994). Coincidence?

Core CPI and GDP YoY

Figure 2: Core CPI and GDP growth YoY

Furthermore, we can look at the core inflation rate (Figure 2, the bottom line) and clearly see that inflation was comfortable around 3%, a very stable level that is around the equilibrium that economists like to talk about so much (but has little to no empirical backing). In fact, it had been on a slow decline for over a year at that point, certainly no reason for the central bank to raise rates to prevent inflation. It stands to reason that if inflation numbers were increasing, then a rational central bank would then react by raising rates to end the trend, but this was not the case at all.

We can then eliminate raw inflation numbers as being the driver of higher rates, what about GDP? The green line in the graph shows that GDP in the late 1993 and through 1994 was going up rather quickly. This could potentially have been seen as a warning sign of future inflation, and thus given bond market participants a reason to sell off Treasuries to go into other securities that may offer better rates of return. Considering inflation was low while GDP was growing quickly, that may have been a concern on the minds of traders, but unlikely to spur such a change in the Treasury market.

Finally, let's take a look at the blue line in Figure 1, representing the effective federal funds rate that the Federal Reserve sets that is essentially the wholesale cost of funding for banks. It begins increasing in 1994, a decision consciously made by Greenspan's Fed at the time. One can clearly see that this increase in the short-term funds rate precedes the increase in 10-year Treasuries. Could it be that the Treasury market participants were merely reacting to Fed policy of increasing rates on short-term bonds? Greenspan sent clear market signals that he and the entire Federal Reserve Board were concerned about future inflation. The logical market reaction is to demand higher rates on safe assets to compensate for this risk.

This seems the most likely reason for the increase in 10-year Treasury yields, since all the other data pointed to low inflation and the market didn't seem to show any other signs of expecting higher inflation.

So far, no sign of any bond vigilantes, just evidence of perhaps an irresponsible Federal Reserve raising short-term rates because of a fear of possible (but never materialized) inflation due to higher GDP numbers being posted. And higher rates set by the Fed would make any marketeer respond with a demand for higher Treasury rates to compensate for a perception of higher inflation in the future -- if the Fed says it's a risk, well you have to respond to it whether it's credible or not!

Greenspan's Federal Reserve Policy during Alleged Attack of Bond Vigilantes

I decided to investigate further by checking out the Federal Open Market Committee minutes from February, 1994, to figure out what exactly these guys were thinking by raising rates. Sure enough, they were concerned about “price pressures” (inflation) and “sustained economic growth” (GDP that is controlled rather than left to spike upward unsustainably):

“In the implementation of policy for the immediate future, the Committee seeks to increase slightly the existing degree of pressure on reserve positions. In the context of the Committee's long-run objectives for price stability and sustainable economic growth, and giving careful consideration to economic, financial, and monetary developments, slightly greater reserve restraint or slightly lesser reserve restraint might be acceptable in the intermeeting period. “
There's no reference in the minutes whatsoever to expected government programs that would lead to higher inflation, and there's certainly no indication that they are responding to bond market rates going up, but here is something they do reference:
“Most market interest rates declined slightly during the intermeeting period, and major indexes of stock prices posted new highs. Market participants saw the incoming news on inflation as encouraging; still, they viewed the economy as relatively robust, and on balance they deemed a firming of monetary policy to counteract a potential buildup of inflation pressures as likely in the next few months, but probably not in the very near term.”
In other words, the Fed was worried about too much private growth that was perhaps viewed as unsustainable, which may lead to upward price action pressure. Not one single mention of the Fed trying to front-run the bond market, or even a single reference to any concern by any of the Board governors. Instead, they're merely talking about how robust private growth could lead to higher prices. So rational bond market participants would then sell bonds in reaction to the apparent consensus that inflation was going to be a problem, which is exactly what happened.

However, inflation at the time was posting numbers below 3%, and back in 1993 they were closer to 4%, so why was inflation a concern in 1994, but not in 1993? The answer is the trend in GDP growth, not any government actions that were merely proposed, not any risk of repayment, not any risk of instability due to perceived inability to repay, and certainly not the result of some bizarre protest in the government bond market.

It could be (and I'll expand on this in a later essay) that Greenspan mismanaged the economy as he had so many times in his long reign at the Fed, and raised rates prematurely, provoking fear of inflation that wasn't that risky after all, given the statistics that were out at the time regarding a slow labor market, low inflation, but high GDP growth. It's these rate increases and talks of high inflation which actually provoked the 10-year Treasury selloff, not a protest against high debt levels or high government spending which would lead to run-away inflation.

Conclusion

Bond market vigilantes do not engage in market transactions as a form of protest. There is little evidence to support this idea, save for perhaps a few stragglers who don't have any real influence in markets anyway claiming they participated in such activities as a protest.

Instead, market participants do what they do to position themselves for what economic conditions are reflecting now and as expected in the future. The Federal Reserve in late 1993 and early 1994 was openly discussing inflation pressures and high growth that needed to be dampened, raising discount and federal funds rates to achieve the goal of stabilizing growth. However, Core CPI was reflecting a continuing downtrend in inflation, rather than any true risk of higher inflation being realized (just higher bond rates).

It seems then that the obvious factors leading to the “attack of the bond vigilantes” were in fact Federal Reserve actions to raise short-term rates to dampen accelerating GDP figures, as well as their open discussions of a risk of future inflation that didn't seem to be a credible threat in hindsight. There was no real attack to punish Washington, but merely a reaction to Fed policy.

In light of all this, it's extremely irrational for individuals to even imply that bondholders are going around selling off Treasuries absent any data indicating higher growth/inflation,as a means to protest policymakers' decisions. It's patently absurd to insist that, in an economic environment where advance GDP just came out at -0.1% annualized for the 4th quarter of 2012, the key Fed rates are all around 0%, and core CPI under 1% consistently on an annual basis, the Treasury investors would sell off their holdings in fear of inflation or overheated growth. There's no basis for this fear given the Fed's current actions and the economic data.

Such discussions serve more to push the hidden agenda politically of those who advocate such risk of attack, namely to dice up any social spending and roll back New Deal progress with austerity touted as the only cure to...stagnantion and near deflation? Er, I mean, crushing deficits and debt! Then again, Democrats are using the same fear tactics, but to promote different cuts. Austerity is unfortunately a bi-partisan Washington consensus.

It's important for the public to know that we won't be running out of dollars and that unstable inflation levels may be a risk (although there's no current indication of that) in some situations, but only really when growth is high and real resources are in a capacity squeeze. Treasury bond rates will not go up until we have growth and inflation that justifies it, as well as corresponding Fed actions on the short end of the yield curve to push it through. We are not in any way beholden to the whims of "bond market vigilantes." The market participants merely react to the data surrounding inflation and growth, particularly any and all of the Federal Reserve's actions (from overt rate changes to signaling policy intent to influence market expectations). They certainly do not get upset about higher government debt levels and "punish" the Treasury market with a sell-off.

In summation, the real driver of higher Treasury bond rates is the Federal Reserve's control of short-term rates, as well as the power of their suggestion of inflation and other risks that lie within their publications, which have such a high influence on bond market participants. In this regard: we have nothing to fear, but the Fed itself.

Originally posted to AusteritySucks on Mon Feb 04, 2013 at 05:09 AM PST.

Also republished by Money and Public Purpose and Community Spotlight.

EMAIL TO A FRIEND X
Your Email has been sent.