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March
03
2023

The Bogeyman Is Loose!
Brian Maher

Rumors swirl… that an abominable bogeyman has risen from the grave… and that he is hot for blood.

He is the scourge of Washington. He is the dread of Wall Street.

This fee-fi-fo-fum’s return — if the sightings can be authenticated — would have markets wriggling in exquisite torture.

What precisely is this creature? And why is he now climbing from the grave?

Answers to follow. First we look in on his ultimate destination, the potential scene of carnage — Wall Street.

No Fears Today

The Dow Jones Industrial Average leapt a lovely 341 points today. The S&P 500 advanced 30 points; the Nasdaq Composite, 83.

We are informed that software firm Salesforce led the happy way forward on the strength of its latest quarterly report. Its stock climbed 11.5% today.

Meantime, 10-year Treasury yields crossed 4% today for the first occasion since November.

Yahoo Finance:

Rates remained a key focus for investors, with the yield on the 10-year Treasury note standing north of 4% after hitting this level on Wednesday for the first time since November.

The rise in yields has come as investors brace for more aggressive action from the Federal Reserve in the coming months as inflation stays elevated and the economy remains strong.

Yahoo Finance hints at the above-described devil’s potential menace.Enter now the protagonist of our frightful and ghoulish tale…

The bond vigilante. The bond vigilante is the monstrous villain detailed above.

The Rise of the Bond Vigilante

Wikipedia defines a bond vigilante thus:

A bond market investor who protests monetary or fiscal policies he considers inflationary by selling bonds, thus increasing yields.

Economist Ed Yardeni hatched the term in 1983.

“If the fiscal and monetary authorities won’t regulate the economy,” argued Yardeni, ”the bond investors will. The economy will be run by vigilantes in the credit markets.”

The Federal Reserve overheated the printing presses in the 1970s.

Inflation had America by the snout — attaining a dollar-devouring 11% by 1979.

It was during this period that the bond vigilante acquired existence. Here is the reason:

Inflation gnaws at the value of bonds as a termite gnaws at pine. And no bondholder is willing to see inflation reduce his bonds to sawdust.

In protest, they threatened to jettison their bonds en masse. This mass bond selling would spiral bond prices to obscene heights and bond yields to obscene depths.

Recall, bond prices and bond yields exist in a state of antagonistic polarity. If prices increase yields decrease. If prices decrease yields increase.

Imagine a seesaw in operation and now you have the picture.

Paul Volcker Routs the Vigilantes

But Mr. Paul Volcker came on station in 1979. “Tall Paul” elevated interest rates so high he licked inflation by 1983.

The bond vigilantes sank into a long, long hibernation. They re-emerged briefly in the early to mid-1990s.

A certain fellow from Hope, Arkansas — perhaps you recall him — planned to open the national cheque book… and spend.

But the awakening vigilantes jammed a gun against his ribs. Ten-year yields jumped from 5.2% to 8% between October ’93 and November ’94.

Thus the bond vigilantes forced Mr. Clinton “to scale back an ambitious domestic agenda,” in Yardeni’s words.

Such was their might, Clinton henchman James Carville adjusted his reincarnation plans:

I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.

Back Into Hibernation

But massive central bank bond purchases following the financial crisis hammered bond yields down and down (increased bond purchases raise the price and depress the yield — recall the swinging seesaw).

By July 2016, 10-year Treasury yields plunged to a record low 1.37%.

Inflation was reduced to a ridiculous rumor. And the bond vigilante was laid away for good.

10-year yields would plumb unfathomable depths in July 2020, under impossible pandemic pressure — to an inconceivable 0.53%.

But the pandemic occasioned the greatest monetary and fiscal spree ever witnessed.

Within 24 months, the Federal Reserve conjured 50% more dollars… than all the dollars that ever existed in 246 previous years of American history.

Can you imagine it?

The Return of Inflation

Unlike quantitative easing — which largely imprisoned dollars within the banking sector —  the fiscal authorities emptied trillions into actual economic circulation.

In 2021 inflation got up on its legs and began to stretch. By June 22 inflation ran riot… summiting 9% last June.

All the while bond yields were on the jump.

From the pandemic trough of 0.53%, 10-year yields skyshot to 4.07% in October. There they presently remain — at 4.07%.

Thus bondholders are yelling for greater yields to jog ahead of inflation.

That is, the bond vigilante is climbing from his grave… and taking to the prowl.

They’re Baaaaaaack

Mr Simon White, Bloomberg macroeconomics crackerjack:

The risk of a structural rise in yields has heightened as bondholders begin to demand more compensation for inflation that is increasingly ingrained…

Term premium, essentially the extra yield long-term bond holders require for inflation risks, has been rising as data show the disinflation trend in the US running out of steam, helping push 10-year yields back over 4%.

In fact, over the last six months we have seen more extreme daily rises (i.e. those in the top 0.5% of all daily moves going back to 1960) in term premium than we have since the early 1980s, when Fed Governor Volcker was in the last throes of his conclusive battle with inflation…

What then are the implications of this bond vigilantism?

The implications are considerable if bond holders are worrying inflation is becoming embedded. Most immediately, yields would be biased structurally higher, and would decline less when the Fed cuts rates, lowering the control the central bank has over longer-term borrowing costs…

In reminder: contrary to the beliefs of many, the Federal Reserve does not directly manhandle the 10-year Treasury yield. It only has its hands on the federal funds rate — the overnight rate at which banking institutions lend.

The Federal Reserve may influence the 10-year Treasury note, it may blow against it, it may speak to it. But it exerts no direct control over it.

“Inflation Is a Social and Behavioral Phenomenon as Much as an Economic One”

Please continue, Mr. White. We would like you to articulate inflation’s effects on the bond market. Tell us how inflationary expectations seep into the marrows:

Inflation is a social and behavioral phenomenon as much as an economic one. At some point, inflation expectations become self-fulfilling and drive inflation itself. An emerging narrative that inflation is becoming persistent adds to the likelihood that that is what we will soon see.

And inflation expectations are already rising at the fastest rate in decades… A structural, term-premium driven rise in yields could take years to reverse as hitherto dormant bond vigilantes become conditioned to a world where inflation is persistently elevated and prone to sudden flare-ups.

It would also mean an end to the uneasy alliance between central banks and markets fostered over the last four decades.

It would likewise represent the triumph of the bond vigilante.

We wish him every godspeed and success. Strength to his arm!

Three Cheers for the Bond Vigilante

Here is the watchman of fiscal honesty. Here is the sentinel watching over the national purse.

Here is Horatio on the bridge, taking his defiant stand for the Republic.

He may be the only reliable check against breakaway federal spending and its attending debts.

Thus do we raise a robust hymn of praise for the bond vigilante.

Of course… he could potentially haul down the stock market to frightening depths.

Yet we must raise this question:

If the stock market would sink under the weight of sound finance… What does that say about the stock market?

Regards,

Brian Maher
Managing Editor, The Daily Reckoning

 

 

Brian Maher is the Daily Reckoning’s Managing Editor. Before signing on to Agora Financial, he was an independent researcher and writer who covered economics, politics and international affairs. His work has appeared in the Asia Times and other news outlets around the world. He holds a Master’s degree in Defense & Strategic Studies.

 

 

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