Bond vigilantes are starting to wake up

By John Authers

Published: December 10 2010 23:20 | Last updated: December 10 2010 23:20

We have been waiting for the bond vigilantes for two years. They are still not doing their damnedest, but this week they
appeared to be waking up.

Vigilantes in the bond market are vigilant over government spending. If they think that politicians are letting inflation
take off (thus diminishing the value of future coupon payments from bonds) or running the risk of default, then they go
on strike.

When fewer people will buy bonds, their price goes down. Thus, their yield, or effective interest rate, must go up. That
makes the bonds a more attractive investment, but it has big ripple effects, as long-term government bond yields are
used as the baseline “risk-free” rate in pricing many financial products and transactions, starting with mortgages. Higher
yields mean more expensive mortgages.

For two years, bond vigilantes have dominated debate, without doing anything. Once it was clear that western
governments’ response to the credit crisis centred on printing money and spending it, this was a logical fear.

But US bond yields have been on a downward trend for a quarter of a century, ever since the market grew to accept that
the Federal Reserve was serious about taming inflation. And that trend remains intact.

Why? Several factors counteract vigilantism. First, with a big overhang of debt, there is reason to fear deflation, or falling
prices. That would make bonds’ coupons grow more valuable over time.

Second, with fear hanging over anything riskier, the place to hide is in government bonds, pushing down their yields.

Third, regulators are pushing investors towards the bond market. Pension funds that need to meet liabilities to
pensioners must stock up on them.

Finally, central banks led by the Fed have been buying up bonds to keep their yields down.

Until this week, the only exceptions to this came on the periphery of the European Union, where vigilantes tested
whether governments were really prepared to make the cuts needed to avert a default. That showed that the
unthinkable – such as default by an economy the size of Spain’s – had become thinkable. But as attacks on the eurozone
were accompanied by a “flight to safety”, with US bonds generally doing well when the European angst was greatest,
faith in American creditworthiness remained.

That calculus changed this week. Starting on Tuesday, 10-year borrowing costs in the US rose 14 per cent in a matter of
hours. Since bottoming on October 7, 10-year yields have risen 37 per cent.

Similar trends were at work in German Bunds, whose yields were at one point up 45 per cent from their low in
September, and in the UK, gilt yields have behaved almost identically. Even in Japan, where bond yields have been far
lower than in the rest of the world for a generation, yields are up 55 per cent since September.

Context is needed. Ten-year treasury yields of little over 3 per cent are very low in historic terms – lower than anything
seen in five decades. And long-term rates in the biggest economies are still lower than they were at the beginning of the
year. The high percentage increases in borrowing costs are because rates in absolute terms are so low.

But it is changes at the margin that affect buying and selling decisions in the economy. And such a sudden and co-
ordinated move means something. What happened?

1
The trigger was Barack Obama’s deal with congressional Republicans over extending Bush-era tax cuts for two more years.

Not only do tax cuts for the wealthy slash revenue, but concessions for poorer Americans that the president extracted in
return – reducing payroll taxes and extending unemployment benefits – will also deepen the deficit. The move may
stimulate the economy, but it is fiscally irresponsible.

As this followed a midterm election dominated by voters’ disquiet over the rising deficit, investors had all the greater
reason for concern. US politicians, even under pressure from voters, seem unable to take the nasty decisions needed to
cut deficits.

But the move was almost uniform across big bond markets. Although Mr Obama provided the catalyst, this is not about
any individual government.

Economic data have been better recently, which is a reason to sell bonds and buy stocks – and indices such as the S&P
500 hit post-crisis highs this week.

Rather than a loss of confidence in US credit, then, this move is best read as a reassessment of the risks for the
economy. Investors shifted towards a belief that inflation, not deflation, is the big risk.

But such a violent move cannot be ignored. Anxiety about sovereign debt and governments’ ability to deal with the
problem remains intense. The scenes in London this week showed how hard spending cuts can be.

The other point about this week is that when the bond market moves, it can be violent and sudden. The vigilantes
remain under control – but governments should be aware that they are out there.