There are men and women alive today who have never felt the cold touch of the bond vigilantes.
These semi-mythical figures threatened to arise during the Obama administration, but never did. They haunted the first Clinton administration to the point of paranoia. They are, simply speaking, bond investors who turn from buyers to sellers when worried about the potential of rising inflation undercutting the value of their investment. Their selling, the threat of which is generally predicated on government spending plans with the power to trigger inflation, would put pressure on bond prices, and drive up yields.
This prospect is troubling for American presidents, who depend on borrowing to finance government operations. If interest rates were to move higher, not only would this interfere with a president’s policy agenda, but those increases would be passed on to consumers and businesses who borrow money at rates based on government bonds. Rising rates could cramp the whole economy and make a lot of people upset.
Hence the “vigilante”: The term suggests investors who take the law into their own hands to protect themselves. During the Obama years, the name became a bogeyman deployed by those with an ideological opposition to his agenda, though as we’ll see, decisions made at the Federal Reserve and in the marketplace kept inflation expectations dampened.
But a new president with plans to borrow more and trade less, and the Fed’s new expectation to hike interest rates three times next year, could change the baseline. The days of boring bond markets might be behind us.
When Bill Clinton came into office, he was the first Democrat elected in 12 years. Bond investors feared a more liberal agenda would mean a repeat of the inflation of the late 1970s that ate up their returns. (Ironically, they forgot that it was Jimmy Carter’s Fed chair, Paul Volcker, who beat rising prices.) “I am concerned about the markets fearing a Democrat,” Clinton told the Wall Street Journal in 1992, just before he was elected. Bond yields popped up after he won, suggesting the markets shared his concerns.
To assure them otherwise, Clinton brought bankers like Goldman Sachs’ Robert Rubin into his White House, and delivered a deficit-reduction plan that included tax increases and spending cuts in the first year of his term, rather than making investments proposed by more left-wing members of his cabinet like labor secretary Robert Reich.
Eventually, Clinton would make Rubin his Treasury secretary, and re-appoint Republican Fed chair Alan Greenspan. Landmark budget deals cut with a Republican congress led to falling federal deficits and, eventually, surpluses. While most of the change in position came from booming economic growth driven by information technology, the end result was a bond market tamed. By the time Clinton left office with full employment in hand, ten-year bond yields had fallen by more than 100 basis points:
The great moderation ends
The experience of the 1990s convinced many economists that properly managed monetary policy would allow the US to prevent major economic disruptions. The short recession that accompanied the popping of the technology bubble in 2001 helped lull policymakers into a false sense of security. A wave of cuts by the Fed accompanied by the massive fiscal stimulus from tax cuts under president George W. Bush soon had the economy humming again.
But it was short-lived. Financial deregulation, low interest rates, and new financial technologies led to a massive boom and a massive bust in home lending. A desperate Fed cut rates to zero even as investors hammered in every other asset class fled to the presumed safety of US government debt. Interest rates fell dramatically:
This is a new world for bond markets. On top of rate-cutting, central banks, led by the Fed, begin buying housing and corporate debt to drive in an effort to stimulate the economy. When Barack Obama came into office with a plan for a massive stimulus effort, some investors predicted disaster and a return of the bond vigilantes. The famed fixed-income manager Bill Gross sold all of his Treasuries, predicting massive inflation to come.
It didn’t arrive, though, for reasons many saw at the time. The recession had left a huge gap in the US economy for public dollars to fill without crowding out private investment, and the Fed’s zero-interest rate policy couldn’t be overcome by private sellers. In any case, few were selling—many still relied on Treasuries as a safe haven in an uncertain global environment. And countries that traded with the US were actively buying US bonds to help keep their currencies competitive. Deflation soon became a bigger concern than inflation.
As the economy healed and growth returned, many policymakers became eager to end of the era of low interest rates. Low rates are problematic for people on fixed incomes, could lead to distortions in asset and currency markets, and make it difficult for the Fed to respond in the event of a new recession.
Finally, in 2015, the Fed raised rates for the first time since 2006.
A new era for bond markets
The Fed’s meeting on December 14 saw the second rate hike in as many years. But what really surprised observers was a forecast from Fed officials for three more rate hikes in 2017, a faster pace of tightening than many had anticipated. In her press conference after the meeting, Fed chair Janet Yellen credited several factors for the decision, including steady job growth, increasing household investment, and, yes, the election of Donald Trump.
“For this year, there was a slight upward revision to inflation,” Yellen said after being asked what had changed, “and some of the participants, but not all of the participants, did incorporate some assumption of a change in fiscal policy into their projections.”
It could be a significant change: Trump campaigned on policies that would add some $5.3 trillion to the federal debt over 10 years, mostly in the form of tax cuts to the wealthiest Americans. While domestic spending cuts are also on the horizon, they are dwarfed by the estimated size of the tax cuts, so increased borrowing is expected.
And during the campaign, Trump mused publicly on the idea of defaulting on US debt, saying that “I would borrow, knowing that if the economy crashed, you could make a deal.” While a frequent user of bankruptcy during his time as a businessman, Trump may not be familiar with the agonies of sovereign default.
So now, unlike in 2010, borrowers are facing higher inflation expectations and may have better options for their investments in the private sector. Analysts are predicting a bond sell-off after yields on two-year government debt hit a 10-year high, and 10-year government bond yields hit a two-year high. Foreign central banks have been selling US bonds for seven consecutive months now.
Some in Trump’s circle are cognizant of the concerns; it’s one of the reasons that Goldman Sachs president Gary Cohn has been brought into the White House to lead the National Economic Council under Trump. On the other hand, Larry Kudlow, a devout believer in the idea that tax cuts pay for themselves, has been appointed to chair Trump’s Council of Economic Advisers.
Ironically, Obama and the Democrats never could convince Republicans in Congress to borrow money for public investments while rates were low. Now, Trump may find a Republican Congress eager to throw away fiscal rectitude like in the days of the second Bush administration, just when the consequences of such an action look all too real.