By: Steven L. Yamshon, Ph.D., Managing Principal
James Carville, President Clinton’s political consultant said at the time when Clinton was President, “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.”
Back in the early 1980’s, bond investors were a force to be reckoned with and these “bond vigilantes” took matters into their own hands when the government was fiscally irresponsible, selling bonds en masse, pushing up interest rates sharply higher and forcing the government to get serious. What is a bond vigilante and why does it matter? The truth is any bond investor is a potential member of this esteemed group. Investors who purchase fixed income products such as bonds want a positive real return on their investment. The real return is the return after inflation, and this is what counts, because it is what your money buys. Inflation erodes your purchasing power.
When the Great Financial Crisis occurred in 2008, the Federal Reserve (the “Fed”) had to use all the tools at their disposal to keep the economy from sliding into a depression. Lowering interest rates is just one tool at their disposal and the Fed lowered interest rates close to zero. To keep interest rates near zero, the Fed implemented a never-tried-before technique called Quantitative Easing (“QE”). Without getting too technical, this operation is called money printing and is equivalent to dropping money from helicopters. In 2008, the Fed had to do this to save the economy. In 2020, the Fed did it again because of the COVID-19 pandemic but at greater speed and intensity. Most likely, this was an overkill, and we believe it will lead to a sustained level of higher trend inflation.
Where are the bond vigilantes? After all they have been in hibernation for a long time. There is one reason and one reason only. Inflation was low until now. However, the U.S. economy may be at a pivotal turning point. If history is any guide the bond vigilantes will most likely wake up in the next several years. In the 1930-1950 period, inflation spiked because of dollar devaluation during the 1930’s and to finance World War II (Chart 1). During this period the Federal Reserve accommodated fiscal spending by their massive power of the printing press.
When President Lyndon B. Johnson wanted to eliminate poverty and pay for the Vietnam War, known as “guns and butter,” he did so without raising taxes. This set off a stagflation period that lasted from 1969 to 1985 and only ended when Federal Reserve Chairman Paul Volcker raised interest rates to 20% (Chart 2). Volcker had no choice. He had to stamp out inflation and the bond vigilantes forced his hand.
By mid-decade, we believe the bond vigilantes will come out of their long-lasting sleep because the U.S. fiscal position will become unsustainable. The budget deficit, and trade balance of payments is exploding upwards. The major reason why the United States is not in the same situation as Buenos Aires, Argentina, is because the U.S. Dollar is the global reserve currency, but that exclusivity is eroding.
At some point investors here and abroad will say “enough is enough” and want increased compensation for the risk of holding U.S. government debt. That is when the bond vigilantes will awaken from the dead like the rise of the Phoenix and sing “Don’t Cry for Me Argentina”.
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