Deficits didn’t matter – until raging inflation brought the bond vigilantes back to life.
By Wolf Richter. This is the transcript of my podcast on Sunday, Oct 16, THE WOLF STREET REPORT.
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.
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.
When they get tired of being beaten up by raging inflation, reckless fiscal policies, and artificially low interest rates, they refuse to buy bonds, and some are selling bonds, and so buyers vanish, and new buyers have to be lured into the market with higher yields and lower prices, or else no one is buying, and this is pushing up interest rates further and pushing down bond prices further, and so these bond vigilantes are imposing high costs of borrowing as punishment.
So what happened in the UK was this: A few weeks ago, with inflation already at 10%, a new government tried to put its stamp on the economy. It came up with a stimulus plan of tax cuts and subsidies that would fire up inflation even more and at the same time would increase the need by the government to borrow large amounts.
The new government announced a package of big tax cuts essentially for the rich: it would scrap the top income tax rate, and it would cancel an increase in corporate taxes. These tax cuts would be accompanied by a surge in spending on energy subsidies for businesses and households.
When inflation is already spiraling out of control, cutting taxes and throwing subsidies out there, that combined would trigger a huge burst in borrowing, is exactly the wrong prescription to get inflation under control. And the UK bond market had conniptions.
Bondholders get eaten alive by inflation because inflation eats the purchasing power of those bonds, and the interest rate, the yield, of those bonds isn’t nearly enough to compensate the bond holders for the loss of purchasing power.
So already when the new government came to power on a platform of tax cuts and increased spending, the bond market started acting up. And then, when they made their announcement in late September, the bond market went haywire.
Back in mid-August, the 10-year yield of UK government bonds – gilts, as they’re called – was still around 2%. By September 26, six weeks later, they’d spiked to 4.5%, which is a huge jump in a very short time. It did that initially because the bond vigilantes stepped away from the market, didn’t buy, or even sold their holdings into the market.
And then the secondary effects set in. The spiking yields caused a group of large pension funds to get in trouble with their so-called “liability-driven investment” strategy, or LDI, which is a leveraged system of derivatives that were using long-dated government bonds as collateral. When yields of those long-dated government bonds spiked, as prices plunged, these pension funds got margin calls from the very investment banks that had sold them those LDI strategies.
And so the pension funds started dumping bonds, and other assets too, to meet those margin calls, and because they were dumping bonds when the bond vigilantes had already stepped away from the market, the UK government bond market essentially fell into panic.
To calm the waters, the Bank of England stepped in with a temporary bond buying program, but has bought much smaller amounts than it had indicated. It is caught between this crisis and inflation that is raging at 10%. So it kept its market interventions much smaller than announced, and they ended on Friday. Bank of England governors said that, at their upcoming November meeting, they would hike interest rates and re-kick off quantitative tightening that they’d delayed because of the crisis. Their number one issue is 10% inflation.
And to further calm the waters, finance minister Kwasi Kwarteng, the co-architect of the new policies and longtime ally Prime Minister Liz Truss, announced that he’d shelve the plan to cut the top tax rate.
But the turmoil and backlash persisted. On Friday, so that was October 14, Prime Minister Truss sacked Kwarteng. So he’s the fall-guy. His sacking prepared the way for her U-turn on the tax cuts.
And the new guy to replace Kwarteng is Jeremy Hunt, a former foreign secretary who is seen as calm and reassuring to the markets.
And Hunt came out and scrapped Truss’s tax-cutting plan just right there on BBC on Saturday, when he told the BBC that some taxes would not be cut as quickly as people want, and some taxes would have to go up. And he said he would move to limit spending. “So it’s going to be difficult,” he told the BBC. He said that Truss had made mistakes with her plan to cut taxes and increase borrowing to fund those tax cuts.
The U-turn happened because the all-important bond market went into a revolt against government policies that promoted even more debt and ever more inflation, at bondholders’ expense.
This was the first real battle that the bond vigilantes fought in many many years. And they won. And this sent shockwaves through the global markets – and it put other governments on notice.
The bond market is hugely important for overindebted countries and companies; it’s hugely important for the United States.
The Federal Reserved is tangled up in the worst bout of inflation in 40 years, and they’ve got to bring this inflation under control by hiking rates and reducing their balance sheet through quantitative tightening, despite economic growth that has essentially stalled. But interest rates on Treasury securities, though they’ve now jumped over 4% for most maturities, are still woefully low, with inflation at over 8% being twice that rate. And bondholders are getting eaten alive by this inflation.
The bond market is in a very sour mood in this environment of high inflation, low economic growth, sky-high government debt and corporate debt, and still very low interest rates that are far below the rate of inflation. These are insidious times for bondholders that have come to rely on the Fed put – via Quantitative Easing and rate cuts – to halt market drops.
And the Fed cannot step in and restart QE and cut interest rates because it would unleash a huge amount of inflation on top of the already raging inflation, and it would just blow up everything.
The Fed put is out the window for the stock market too. When inflation is raging, there cannot be a Fed put. The markets have to find their way through this on their own.
And what happened in the UK shows just how powerful the bond market can be when it is getting abused by raging inflation, artificially low interest rates, and reckless government policies.
The bond vigilantes might re-emerge in the US too finally, and rattle some nerves and threaten to impose some much-needed discipline on Congress whose reckless spending practices have gone haywire over the past many years of ultra-low interest rates. Deficits really don’t matter – until raging inflation brings out the bond vigilantes.
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