The bond vigilantes are back

Receive free Markets Insight updates

We’ll send you a myFT Daily Digest email rounding up the latest Markets Insight news every morning.

The writer is president and chief investment strategist at Yardeni Research

I graduated from Yale University’s PhD programme in economics six years after Janet Yellen did so in 1971. We both studied under Nobel laureate Professor James Tobin. Nevertheless, she is a liberal and I am a conservative when it comes to economic policymaking. I coined the phrase “bond vigilantes” four decades ago. Now, as the US Treasury secretary, Yellen should be very worried that the vigilantes will upend the best-laid plans of her boss, president Joe Biden, which she wholeheartedly endorsed and promoted.

I first wrote about the bond vigilantes on July 27 1983 as follows: “So 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 markets.”

Currently, monetary policy has been on the right course, with the Federal Reserve focusing on fighting inflation, which soared in 2021 and 2022 after Yellen’s Treasury department provided a third round of pandemic relief cheques to millions of Americans in early 2021. That fuelled a consumer buying binge that was already under way in response to the first two rounds of cheques under the Trump administration during 2020. The buying binge caused prices to soar.

The Fed reversed course in early 2022 and aggressively tightened monetary policy to fight inflation. That same year, the Biden administration succeeded in enacting fiscal spending programmes that significantly worsened the projections for the federal budget over the next 10 years. Nevertheless, the deficit narrowed briefly during 2022 and early 2023 because individual income tax receipts were bolstered by taxes on capital gains when lots of investors sold their shares during last year’s bear market.

This year, inflation caused the government’s outlays on social security to rise more rapidly since they are indexed to inflation. More worrisome is that the Fed’s interest rate increases in response to inflation are causing the Treasury’s outlays on net interest to soar. Meanwhile, tax revenues have turned down following last year’s temporary windfall. So the federal deficit has ballooned to $2tn over the past 12 months through August.

And now the spending binge under Bidenomics is about to kick in. Needless to say, the Treasury secretary and I can debate whether the administration’s Inflation Reduction Act is a misnomer. But there’s no debating that the rising deficit will require the Treasury department to issue lots more Treasury securities.

In recent weeks, the bond vigilantes have been challenging Yellen’s policies by raising bond yields to levels that threaten to create a debt crisis. In this scenario, higher yields crowd out the private sector and trigger a credit crunch and a recession. Since the root cause of the problem is profligate fiscal policy, the government would have to cut outlays and boost taxes to placate the bond vigilantes, which would exacerbate the recession.

At first, in 2022 and 2023, the bond vigilantes followed the lead of the Fed. Recognising that they had fallen behind the inflation curve, Fed officials scrambled to get ahead of it by raising the federal funds rate aggressively by 5.25 percentage points since March of last year. Bond yields rose along with the federal funds rate until the summer of 2022, when the yield curve inverted as the bond yield rose less rapidly than the federal funds rate.

In the past, an inverted yield curve signalled that bond investors anticipated that if the Fed continued to raise short-term rates, something would break in the financial system resulting in a widespread credit crunch and recession. That script started playing out in March of this year when a banking crisis occurred, but it was swiftly contained by the Fed, which provided an emergency liquidity facility for the banks.

The bond yield fell to 3.3 per cent during the crisis. It rose to around 4 per cent during the summer, as fears of a financial crisis and recession abated, causing the Fed to continue raising the federal funds rate. But the yield curve started to disinvert in June, with the bond yield rising faster than the federal funds rate as the bond vigilantes became increasingly alarmed and animated about profligate fiscal policy.

The bond yield has gone vertical in recent weeks, jumping to 4.80 per cent on Tuesday. If it continues to soar up to 5 per cent or higher, Yellen should meet Biden to explain that the bond vigilantes are about to trigger a crisis that could derail his chances of winning another term.

The bond vigilantes’ heyday was the Clinton years, from 1993 to 2001. Placating them was front and centre on the administration’s policy agenda. Now they are back.