Oct 23, 2023 - Economy

Bond vigilantes factor into the changing interest rate environment

Illustration: Shoshana Gordon/Axios

Usually, when there is geopolitical strife, money gushes into ultra-safe U.S. Treasury bonds, pushing interest rates downward. But since the Hamas attack on Israel three weeks ago, the opposite has happened.

Why it matters: Soaring rates, even in this moment of conflict, is a sign that bond markets are now being driven in significant part by the outlook for future U.S. government borrowing.

  • In effect, the bond vigilantes — the term for bond investors whose buying and selling reflects judgments on a country's fiscal outlook — look to be a factor in the changing interest rate environment in a way they haven't in years.

Driving the news: Following the Oct. 7 attack on Israel, there was an initial rally in Treasuries of the sort often seen when war looms. But that has since reversed, sending long-term U.S. borrowing costs upward.

  • The 10-year Treasury note yielded 4.78% before the attack. On Monday morning, it surpassed 5% (it was down to 4.87% at 11:30am ET — more on why below).
  • One factor appears to have been the anticipation of more federal borrowing — and hence debt issuance — to provide military aid to Israel as well as Ukraine.
  • "America can certainly afford to stand with Israel and to support Israel's military needs and we also can and must support Ukraine in its struggle against Russia," Treasury Secretary Janet Yellen said last week.

What they're saying: "Bond vigilantes have reacted to the 'higher for longer' narrative and fiscal deficit concerns, while supply cuts and geopolitical tensions in the oil market have put upward pressure on prices," said Seema Shah, chief global strategist of Principal Asset Management, in a note.

Flashback: The term "bond vigilantes" was coined by analyst Ed Yardeni in 1983 to describe the role of debt investors in disciplining governments by selling off bonds of those that look to be profligate or irresponsible.

  • "If the fiscal and monetary authorities won't regulate the economy, the bond investors will," Yardeni wrote then. "The economy will be run by vigilantes in the credit markets."
  • The concept had a comeback in the early 2010s, when many commentators argued the United States needed to aggressively tighten fiscal policy, lest it incurs the vigilantes' wrath.
  • It didn't really describe the dynamics underway at that time. The economy was still clawing out of a deep recession, inflation was very low and the Federal Reserve's target interest rate was stuck near zero with bond purchases underway.

Yes, but: Today's circumstances look rather different, with elevated inflation, strong growth, the Fed holding its target rate above 5% and shrinking its bond portfolio.

  • Moreover, the fiscal outlook for the coming decade is meaningfully worse now than it was then.
  • For example, in projections from August 2011, the Congressional Budget Office envisioned a fiscal deficit averaging 1.8% of the economy in the ensuing decade. That number was 6.1% in the most recent projection from this past May.

One such bond vigilante — at least until very recently — was Bill Ackman, the billionaire founder of Pershing Square Capital Management.

  • He said in August that "I have been surprised how low US long-term rates have remained in light of structural changes that are likely to lead to higher levels of long-term inflation, including de-globalization, higher defense costs, the energy transition, growing entitlements, and the greater bargaining power of workers."

The latest: On Monday morning, Ackman said on social network X that he has closed out his bet against Treasuries.

  • "There is too much risk in the world to remain short bonds at current long-term rates," he said, adding that "[t]he economy is slowing faster than recent data suggests."
  • That announcement — in effect, that one prominent vigilante had concluded the bond rout might be over — drove yields lower.

Between the lines: The fact that Ackman's announcement — from one investor in a multitrillion-dollar market — prompted such a large swing in prices shows that sentiment among major bond investors about the outlook is driving yields right now.

The bottom line: Whether Ackman turns out to be right or wrong about the rout in bond prices nearing an end, it is clear that investors are paying closer attention to the fiscal outlook — and that policymakers can't count on bottomless demand for Treasuries at any price.

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