16th October 2023
Return of the bond vigilantes
When interest rates were nearly zero and inflation was under control, central banks could engage in quantitative easing, with the US Federal Reserve buying billions of dollars’ worth of government bonds each week and showing little concern over the ability to finance ballooning budget deficits. However, with interest rates over 5% and bond yields rising sharply, the cost of financing those deficits and the significantly enlarged stock of debt is increasingly a concern. This has brought the so-called “bond vigilantes” (see definition below) back into focus as investors seek to explain the rise in bond yields at longer maturities. Previously bond yields have risen most at shorter maturities as interest rates rose leading to an inverted yield curve, that is where the yield is higher for shorter maturity bonds compared to longer dated bonds. This has historically been a precursor to recession. Over the last few months the action has been at the longer end as the chart below shows. A week ago the move was much bigger but yields have fallen back over the last week following the Hamas assault on Israel, which we discuss later.
Yields on US government bonds have risen sharply over the last month, particularly for bonds with 10+ years to maturity
Source: Artorius, Bloomberg
The term “bond vigilante” was originally coined by economist/strategist Ed Yardeni in the 1980s when he wrote that “…if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit market.” These comprised banks, hedge funds, and insurers, who would aim to enforce fiscal discipline by driving up government borrowing costs when they perceived that a government is mismanaging its economy and jeopardising its creditworthiness. Such was the power of the bond market that in the 1990s, the US Democratic political adviser James Carville famously said, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
In a world of low interest rates and quantitative easing, the power of the bond market has been quiescent, but as US interest rates surpassed 5%, and the benchmark 10-year Treasury bond yield reached its highest point in 16 years, the bond market is back with a vengeance driving up government borrowing costs and causing turbulence across the yield curve.
One way to gauge the impact of bond vigilantes is by looking at the term premium, which measures the extra yield investors demand to hold longer-term bonds. As the chart above shows there have been significant moves up. In our note last week, we highlighted that the move up in yields has not been accompanied by a corresponding rise in inflation expectations, so why might that be? Why are investors now demanding a higher yield to buy the same bond?
Firstly, this could simply be a case of supply and demand. Treasury issuance is set to increase sharply in order to service budget deficits and an increased stock of debt following significant government support through the pandemic and beyond, combined with a significantly higher cost of debt as bond yields have risen. Who will buy this extra debt and at what price? The Federal Reserve was a buyer of US treasuries under quantitative easing but has become a seller under quantitative tightening, so one investor who bought irrespective of price has disappeared. Other investors are more price sensitive.
Political instability in the US is also an issue (there is currently no speaker in the US House of Representatives after Kevin McCarthy was brought down) and a government shut down remains a possibility, and with it the risk of a default. Congress is starkly divided and this may well be an ongoing issue in the absence of a larger shift in support to one of the parties.
Geopolitical risks remain heightened and often have an outsized impact on commodity prices, which could lead to greater inflation volatility going forward. The war in Ukraine and the resulting commodity spikes (most notably natural gas and oil), which exacerbated inflationary forces, highlights how geopolitical events can significantly impact inflation and the economy.
Lastly, perhaps this reflects a reassessment of the strength of the US economy and the future rate of growth. Economic growth remains robust (and notably stronger than in Europe) and so interest rates may need to stay higher for longer to offset the inflationary effect of higher growth, in which case higher bond yields across the curve could make sense.
Multiple factors are at work but what is clear is that we seem to have moved into a world of higher interest rates and bond yields. This provides a different set of opportunities as an investor and makes a higher allocation to fixed income more appealing. Higher yields are already attractive but, as and when interest rates peak, history suggests that bonds can perform strongly.
Israel and Gaza
With the unfolding situation in Israel and Gaza, it seems almost trivial to discuss the investment implications of the conflict. In the short-term there has been some flow of money towards safe havens, with government bonds (as discussed above) recovering somewhat and there has been some weakness in riskier assets. However, the impact has so far been relatively muted. The wider concern is of an escalation that could bring militias in Lebanon and Syria into the fighting and in a more extreme case lead to direct conflict with Iran, who are the main supplier of money and arms to Hamas. In that scenario, there is an increased risk that the global economy could tip into a recession.
Gareth Thomas Head of Investment Management
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