Many eulogies have been written for the “bond vigilantes” that were once said to prowl global markets for spendthrift countries to bully into fiscal rectitude. But the vigilantes seem to have saddled up again.
The term was originally coined by former EF Hutton economist Edward Yardeni in the early 1980s to describe how bond sell-offs could force the hand of central banks or governments. The concept was later immortalised by James Carville, an aide to President Bill Clinton who in 1994 ruefully wished he could be reincarnated as the bond market so he could “intimidate everybody”.
For the past two decades there has been little sign of the vigilantes. Inflation remained quiescent globally, and a desperate hunger for returns eroded the discipline of many bond investors. Since the financial crisis, central banks have smothered fixed-income markets with a succession of vast quantitative easing programmes that neutered any would-be vigilantes.
But 2021 has seen a disconcertingly swift and powerful bond market rout. The 10-year US Treasury yield — arguably the most important interest rate in the world as it influences prices in virtually every other corner of financial markets — jumped from under 1 per cent at the start of the year to over 1.6 per cent amid tumultuous trading.
As the pandemic starts to wane, many governments around the world have promised to “act big” to spur recovery and repair the economic scarring of the past year. But some analysts now believe the bond vigilantes are riding again — and could undermine the economic recovery and on unsettle booming financial markets.
“We’re in a brave new world of excesses in fiscal and monetary policy, and that’s where the bond vigilantes thrive,” Yardeni says. “It’s their job to bring law and order back to the economy when the central banks and the fiscal authorities are lawless. And that’s arguably what we’re seeing here.”
The central reason for the global bond sell-off is a positive one: although the economic scars from the Covid-19 pandemic remain significant, the combination of ample financial stimulus and pent-up demand being unleashed by the rollout of vaccines means that analysts are rushing to ratchet up their growth forecasts for 2021. Many now expect the biggest economic boom in generations.
However, some fear that this could finally reignite long-dormant inflationary pressures. Inflation is the nemesis of bonds, because it erodes the real value of the fixed interest rates that they pay. Central banks have vowed to stay their hand as long as unemployment remains elevated, but the deepening bond dive shows that markets are beginning to be sceptical of that promise.
For now, most analysts and investors stress that even if inflation is likely to accelerate in 2021, it is likely to prove a fleeting phenomenon, and not something that will pose a serious, longer-term challenge to fixed income markets. While the recent rise in yields has been notable for its speed and power, bond yields remain astonishingly low by historical standards, and some investors now reckon they have moved too far, too fast and are likely to stabilise soon.
Nonetheless, others worry that with investors so accustomed to low bond yields, even a modest rise could upset the dominant fuel of the “everything rally” across markets. Stock markets have already started trembling at the recent uptick, and bond market sell-offs have a nasty way of revealing unexpected faultlines.
“We will certainly get an overshoot. The question is whether the market structure is now vulnerable enough that you’re going to have that echoed and exacerbated in ways we’ve not seen previously,” says Joyce Chang, chair of global research at JPMorgan.
The post-Covid economy
Almost exactly a year ago this weekend, Italy abruptly quarantined 10 towns to limit the outbreak of a novel coronavirus originating in China. The move hammered home that a pandemic was a serious, global threat, and turned simmering nervousness into a full-blown financial market meltdown by March.
Highly rated government bonds are the investment world’s panic room, a safe space where everyone from sovereign wealth funds and insurance companies to money managers and individual savers instinctively head to when times are tough. That causes their prices to rise, and pushes down their effective interest rate, or yield.
When Covid-19 rattled markets, the bond yields of countries from the US to Finland, Germany to Australia, France to the UK, plunged to fresh lows that in some cases made even past records seem dowdy. But since last summer, sovereign bond yields have been creeping steadily up.
The first big impetus came from the emergence of several highly effective vaccines last November, which meant investors could finally start to contemplate what a post-Covid global economy might look like in 2021. Then Democrats won control of the US Senate in January, making possible another big stimulus package that would swell the deficit but hopefully ensure a powerful economic upswing that balms some of the scars left by the pandemic.
JPMorgan Asset Management estimates that the combined central bank and government stimulus measures already totalled $20tn last year, or more than a fifth of global economic output. Now some economists fret that the additional $1.9tn spending package being readied by President Joe Biden’s administration may overheat the US economy.
Pimco, a bond investment group, expects that this additional Covid-19 relief package will boost the US budget deficit to a record $3.5tn in 2021, and lift the annual growth rate to over 7 per cent. That is a pace that has only been hit in three quarters since the 1950s — all of them in the inflationary 1970s and 1980s, Pimco notes.
Dan Ivascyn, Pimco’s chief investment officer, is sceptical that inflation will take off, but stresses that the economic environment is unique. “There’s a lot of stimulus at a time when the economy is starting to show some strength. And that understandably makes bond markets nervous,” he says.
Dan Fuss, vice-chair at US asset manager Loomis Sayles, has seen many economic cycles through his six-decade career as a bond investor, and he is worried that history shows that the scale of the stimulus will inevitably reignite inflation. “I can almost hear Milton Friedman shouting ‘look out here it comes’,” he says. “Can it work out differently? Of course. Is that the way to bet? No, it’s not.”
Notably, the primary drivers of the bond market sell-off have subtly shifted in recent weeks. While the increase in yields since November was primarily powered by rising inflation expectations, the latest moves have largely come from investors starting to price in central banks tightening monetary policy more quickly than they have previously indicated.
That is particularly dangerous for other financial markets, as sub-zero “real”, inflation-adjusted yields have been the dominant reason why investors have felt comfortable paying more for a range of other financial securities than they have in the past. “You’ve built these mini pockets of speculative excess that arguably could be subject to more profit-taking if this continues,” says Liz Ann Sonders, chief investment strategist at Charles Schwab.
Underscoring this tense relationship, equity markets have recently seesawed nervously on days when yields have climbed higher, even though the fundamental reason is rising economic optimism. More than $800bn has been sliced off valuations of the companies that make up the Nasdaq Composite over the past two weeks.
Although most real yields remain negative across most major government bond markets, Matt King, a Citi strategist, notes that the threshold for rising real yields to trigger sell-offs across markets seems to be falling. “The more dovish central banks are, the more money they pump into the system, the more dependent markets become on that money to maintain high valuations,” says King.
Reacting to turbulence
Nonetheless, most investors and analysts are sceptical that a new era of inflation is dawning given the scale of the economic devastation left in the wake of the pandemic, and longer-term deflationary forces like ageing demographics, global supply chains and technological innovation.
Seth Carpenter, chief US economist at UBS, also envisages only a shortlived inflation burst. Spending on services will surge as lockdowns end, yet spending on goods will probably fall as people choose to visit restaurants and do less shopping online. Furthermore, much of the additional stimulus cash coming into households will go to repaying overdue debts, Carpenter says.
Central bankers have this week been at pains to stress that they will not tighten policy to stem an expected inflation spike this year, and that they are keeping a close eye on the bond market reversal. The Reserve Bank of Australia has already restarted its quantitative easing programme, and some analysts expect that others may take action to ensure that the fixed income rout doesn’t deepen further into something more destructive.
The dramatic shifts this week may precipitate action sooner rather than later, argues Scott Minerd, global chief investment officer of Guggenheim Partners. “This volatility is starting to have a real impact in financial markets and given the excessive amount of leverage in the system . . . we are running the risk that we are going to have financial instability,” he says. “Ultimately the Federal Reserve may have to become even more aggressive to keep markets from becoming more chaotic.”
However, the bond vigilantes’ comeback tour may be a shortlived one. Robert Michele, chief investment officer at JPMorgan Asset Management, points out that the Fed is still buying $120bn of bonds a month. Add in the purchases of other central banks and there is a global tsunami of money that will eventually manage to quell the turbulence, he expects.
“At some point — and it may be now — there will be a capitulation, yields will have gotten too high, and the relentless weight of the bond purchases from the central banks will stabilise the market,” he says. “The asset purchases are relentless. You can’t fight that.”