The Bond Vigilantes Are Coming To America

Bond markets will take over the government's fiscal issues if officials don't act.

‍

In the early 1990s, American leaders paid a great deal of attention to how bond investors would react to their decisions. There is a famous quote from James Carville, who served as a political strategist for Bill Clinton, in which he stated that he would like to be reincarnated as the bond market, since "you can intimidate everybody".

‍

It is fair to say that since then, they have largely stopped caring about it. Unfortunately, it looks like they are in danger of being attacked by bond vigilantes in the near future.

‍

There has been a remarkably docile bond market for most of the last two decades. Despite the low yields, the term premium - a measure of the average difference between the yields on long-term Treasury bonds and those on very short-term Treasury bonds - has declined from more than 100 basis points before the 2008 financial crisis to about zero now.  Due to the disappearance of the premium, it suggested that there was a lack of concern for the sustainability of the US government's finances or an extreme lack of concern about inflation.

‍

Three factors are set to change that.

‍

First of all, the economic context is changing. Aside from providing a hedge against recession, bonds' guaranteed interest payments also provided a hedge against the risk of short-term rates getting stuck at the zero lower bounds, even when we were experiencing slow growth after 2008. The problem is that since last year's surge in consumer prices - which led to a rise in the yield of the 10-year Treasury notes by two percentage points and a 15% drop in the price of the notes - they are perceived as being much more vulnerable to the risk of higher inflation in the coming years.

‍

Second, the United States borrows too much. Over the next decade, the Congressional Budget Office estimates that the federal budget deficit will surpass 5% of gross domestic product, which will result in the total federal debt held by the public reaching a record of 118% of GDP, exceeding the prior peak of 118% reached at the end of World War II. Given that the CBO is making three optimistic assumptions, including that the government's longer-term borrowing costs will be lower than they are right now, that the tax cuts that were enacted in 2017 will expire at the end of 2025, and that the current economic expansion will continue for another 10 years, that estimate might be an underestimate.

‍

The third problem is that neither President Joe Biden nor Congress is likely to address the government's fiscal problems anytime soon. While both the Biden administration and the Republican-controlled House advocate prudence, they couldn't be further apart on how to proceed. By raising taxes on wealthy households and large corporations, President Biden plans to raise $2 trillion over the next decade. On the other hand, Republicans are pushing for draconian cuts to consumer spending. Their goal is to cut crucial safety-net programs, such as food stamps, rather than reform the big entitlement programs.

‍

The main question, then, is when bond investors will recognize the risks associated with the bond market and respond to them accordingly. There is a good chance that when that moment comes, it will happen fast and will be self-reinforcing as well. There would be an increase in government borrowing costs as a result of weakening demand for Treasury bonds, further worsening the government's financial situation and unnerving investors. Until politicians are forced to compromise and act in a more fiscally responsible manner, yields are likely to continue to rise in an upward spiral.

‍

Federal debt ceilings are one potential trigger. Sometime this summer, the Treasury will be unable to meet all its obligations due to this arbitrary borrowing limit. There has been no disaster caused by Congress in the past, but this time may be different: Republican House Speaker Kevin McCarthy could lose his speakership if he cuts a deal, and President Biden has said he won’t negotiate because the debts in question are the result of tax and spending decisions already made by lawmakers.

‍

If a compromise is not reached between the two sides, it would shock the financial markets, which are expecting a last-minute compromise as in the past. It is inevitable that investors will wonder what the Treasury will do in the event that it manages to prioritize payments and avoid an outright default on government debt, even if it manages to prioritize payments. Furthermore, the related sharp contraction in government spending would directly threaten the economy. It is estimated that only between 65% and 75% of non-debt service expenditures will be covered by incoming revenues.

‍

Aiming for the debt ceiling would be the absolute worst and dumbest way to deal with the unsustainable budget deficits that we are experiencing. In the end, it could only be hoped that politicians will be able to come to their senses and agree to a responsible fiscal consolidation before the bond vigilantes force them to do so.