by Wolf Richter, Wolf Street:
Deficits didn’t matter – until raging inflation brought the bond vigilantes back to life.
Over the past three weeks or so, we had some spectacular chaos in the United Kingdom’s bond market that then threatened to topple big pension funds that then threatened to spread the damage further into the financial system. In the process, the British pound got hammered to record lows against the US dollar.
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This was triggered by the brand-new government’s announcement of the biggest tax cuts since the 1970s, tax cuts for the rich and for corporations, and some extra spending, all of which would have to be funded by selling even more new bonds into a bond market that is already getting eaten alive by 10% inflation combined with way-too-low interest rates, and by a government that is already over-indebted just as economic growth is stalling. And that’s when we saw them for the first time in many many years: the bond vigilantes.
The bond vigilantes can be brutal, and they can be fast-moving, and they can come out of nowhere, and suddenly they’re here, and chaos ensues, and bond prices plunge, and yields spike, and liquidity vanishes, to the point that it threatens the functioning of the bond market, and therefore the functioning of the economy, and it forces politicians and governments to change policies.
Bond vigilantes can intimidate anyone – because in an economy that runs to a large extent on debts, when the cost of these huge debts spike, and when liquidity in the bond market disappears, all heck breaks loose, and scary stuff can happen. So when the bond vigilantes come to town, it can get wild.
Bond vigilantes came out of the 1970s and 1980s in the US, when bond holders were clobbered half to death by waves of ever-worse inflation. And when inflation finally began to subside in 1983, bondholders remained leery and unwilling to believe, after the misery they’d been through, that inflation wouldn’t return. And they were leery of the ballooning government deficits that they would have to fund. And so US Treasury yields remained high and came down only slowly, and then suddenly surged again, to the greatest frustration of the Reagan, Bush, and Clinton administrations.
Deficits don’t matter – until the bond vigilantes ride into town.
But central bank money-printing and interest rate repression since the Financial Crisis had done away with the bond vigilantes. It’s like they were taken out the back and shot by central banks. Relatively low inflation rates at the time made that possible.
Now everything has changed. Inflation is raging, central banks are tightening and hiking their rates to combat inflation, but economic growth is stalling, and central banks have to keep tightening despite stalling growth because inflation is raging, and the bond market has been taking big losses as interest rates are spiking, and bond prices are falling.
So this is not the kind of environment to spook bond markets with reckless fiscal policies.
What happened in the UK was the first re-appearance from the dead of the bond vigilantes in maybe decades, and they fought their first battle, and they won, and after they won, they’re sticking around and are not going away. This sent shockwaves into the rest of the world, and bond yields have jumped all around.
Bond vigilantes is a figure of speech. They’re big institutional investors that buy government bonds sometimes with a lot of leverage and via complicated derivatives. They’re insurance companies, pension funds, bond funds, hedge funds, even individual investors.
