Bonds I: Eulogy. Let me begin my eulogy for the Bond Vigilantes with apologies to William Shakespeare. The emotional eulogy for Julius Caesar that Shakespeare penned for the character Marc Antony in his play Julius Caesar inspired the words that I would like to share with you on this solemn occasion: Friends, countrymen, citizens of the world, lend me your ears. I come to bury the Bond Vigilantes, not to praise them. The noble Fed killed its rival, the Bond Vigilantes, because they were too ambitious. If it were so, it was a grievous fault. The Bond Vigilantes sought to marshal market forces to counter the ever-growing power of the government. That cause is noble and good. But while the evil that men do lives after them, the good is oft interred with their bones—so let it be with the
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Friends, countrymen, citizens of the world, lend me your ears. I come to bury the Bond Vigilantes, not to praise them. The noble Fed killed its rival, the Bond Vigilantes, because they were too ambitious. If it were so, it was a grievous fault. The Bond Vigilantes sought to marshal market forces to counter the ever-growing power of the government. That cause is noble and good. But while the evil that men do lives after them, the good is oft interred with their bones—so let it be with the Bond Vigilantes. Their well intentioned efforts were doomed to failure. The Fed meant well too, as did Caesar’s assassins. Both comprise honorable men. But men have lost their reason. Bear with me; my heart is in the coffin there with the Bond Vigilantes, and I must pause ’til it come back to me.
Bonds II: Requiem. My friends, I still fondly recall the days when the Bond Vigilantes rode high and mighty. The July 27, 1983 issue of my weekly commentary was titled “Bond Investors Are the Economy’s Vigilantes.” I concluded: “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.”
To this day, every time bond yields rise significantly almost anywhere in the world, I get asked to appear on at least one of the financial news TV networks to discuss whether the Bond Vigilantes are back. Having popularized “hat-size bond yields” and “Bond Vigilantes,” I’ve learned to appreciate the power of coining pithy terms to brand my economic and financial forecasts. Coin a good phrase that accurately describes future developments, and it will appear in your obituary, if not on your tombstone.
The Bond Vigilantes Model tracks the rise and fall of the Wild Bunch. It simply compares the bond yield to the growth rate in nominal GDP on a year-over-year basis (Fig. 1). My model shows that since 1953, the yield has fluctuated around the growth rate of nominal GDP. However, both the bond yield and nominal GDP growth tend to be volatile. While they usually are in the same ballpark, they rarely coincide. When their trajectories diverge, the model forces me to explain why this is happening. On occasions, doing so has sharpened my ability to see and understand important inflection points in the relationship. Here is a brief nostalgic walk down Bond Street:
(1) Getting whipped by inflation. From the 1950s to the 1970s, the spread between the bond yield and nominal GDP growth was mostly negative (Fig. 2). Investors underestimated the growth rate of nominal GDP because they underestimated inflation. Bond yields rose during this period but remained consistently below nominal GDP growth. Those were dark days for bond investors.
(2) Keeping law and order. The Bond Vigilantes were increasingly in command during the 1980s and 1990s. They fought to bring back law and order in the fixed-income markets to the benefit of bond investors. There were several episodes when rising bond yields slowed the economy and put a lid on inflation.
The Bond Vigilantes’ heyday was the Clinton years, from 1993 through 2001. Placating them was front and center on the administration’s policy agenda. Indeed, Clinton political adviser James Carville famously said at the time, “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
(3) Long siesta. After the mid-1990s, the Bond Vigilantes seemed less active, because they no longer had to be as vigilant. As inflation fell, the spread between the bond yield and nominal GDP growth narrowed and fluctuated around zero. While today the US government faces the problem of persistently big federal budget deficits, it’s interesting to recall that at the start of 2001, a major topic of discussion was how big the coming surplus in the federal budget might get.
During the early 2000s, after the 9/11 terrorist attacks, the Fed kept the federal funds rate too low, and a global savings glut kept a lid on bond yields and mortgage rates. They remained relatively flat even as the Fed started raising the federal funds rate “at a measured pace” of 25bps moves, from 1.00% to 1.25% on June 30, 2004 up to 5.25% through June 29, 2006 (Fig. 3).
(4) Long good buy. The Great Financial Crisis (GFC) of 2008 caused the Fed to implement ultra-easy unconventional monetary policies. The federal funds rate was pegged in a range of 0.00%-0.25% from December 16, 2008 through December 16, 2015. The Fed’s three QE (quantitative easing) programs caused the Fed’s holdings of bonds to balloon from $0.48 trillion during the final week of November 2008 to $4.19 trillion by the start of October 2014 (Fig. 4). Inflation remained remarkably subdued after the GFC. Starting January 2012, the Fed targeted core PCED (personal consumption expenditures deflator) inflation at 2%, but it has remained below that pace during all but 13 months since then (Fig. 5).
The Fed’s QE3 was terminated near the end of 2014, and the federal funds rate was raised for the first time since the GFC on December 16, 2015. Fed officials continued to ratchet rates higher up to 2.25%-2.50% on December 19, 2018. They were expecting to normalize monetary policy (Fig. 6).
Nevertheless, investors, reaching for yield, poured money into bonds. The 10-year US Treasury bond yield fell to 1.92% at the end of 2019 (Fig. 7). It was a long good buy from the peak in its yield of 15.84% back on September 30, 1981 (Fig. 8).
(5) Last rites. The bond yield fell below 1.00% for the first time on March 5, 2020, and has been consistently below since March 20. The World Health Organization declared a pandemic on March 11. The Fed responded to the Great Virus Crisis (GVC) by lowering the federal funds rate by 100bps to zero and implementing QE4 on March 15. On March 23, QE4 was turned into QE4Ever. The bond yield fell to a record low of 0.55% on Friday. The Bond Vigilantes have been buried by the Fed.
Bonds III: The Inflation Scenario. Many investors who profited from the long good buy are now saying “you are dead to me” to the bond market. They are rebalancing more of their portfolios into other assets, such as US stocks, SPACs (special-purpose acquisition companies), precious metals, and overseas assets including currencies, stocks, and bonds.
The end of the long-term bull market in bonds has been declared, erroneously, by market prognosticators for many years. It may not be over just yet. The yield on the 10-year Treasury could still fall to zero. It could even turn slightly negative, as have comparable yields in Germany and Japan (Fig. 9).
Then again, what if a vaccine and effective treatments are discovered to end the pandemic early next year? Never before has the drug industry received billions of dollars to develop such medicines at warp speed. In this scenario, the global economy could recover quickly next year. Inflation could finally jump above the Fed’s 2.0% target as demand for goods and services outstrips supply, especially if global supply chains have been significantly disrupted by the pandemic and by the worsening Cold War between the US and China.
Would rising inflation cause bond yields to soar? I don’t think so. Both monetary and fiscal officials know that rising interest rates could abort the post-GVC recovery. They also realize that a rebound in interest rates would significantly balloon federal deficits and the debt. Net interest paid by the federal government totaled $346.9 billion over the 12 months through June, down from a record high of $384.8 billion during March (Fig. 10).
I believe that the Fed publicly would welcome inflation in a range of 2.0% up to 4.0% as a long overdue offset to inflation running below 2.0% for so long in the past. In this scenario, the Fed might announce that the federal funds rate will be held at zero and that the bond yield will be pegged below 1.00%. In other words, any sign that the Bond Vigilantes might rise from their graves (along with inflation) would be met by the Fed with whatever it takes to keep them buried. This would be wildly bullish for all of the alternative assets to bonds mentioned above, especially growth stocks and precious metals.
My view that the Fed’s attitude toward rising inflation is evolving into one of benign neglect was confirmed by an important August 2 article by Nick Timiraos, the WSJ’s ace Fed watcher, titled “Fed Weighs Abandoning Pre-Emptive Rate Moves to Curb Inflation.” Timiraos reports that the Fed “is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it has followed for more than three decades.”
The Fed first formally targeted inflation in a January 25, 2012 press release titled “Federal Reserve issues FOMC statement of longer-run goals and policy strategy.” It stated: “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.” The widespread interpretation was that once the target was achieved, it would be a ceiling.
Timiraos reports that some Fed officials wouldn’t mind if inflation were to run hot above 2% for a while since it has run cold for so long. They want to offset previous deviations on the downside with a stretch of inflation overshooting the 2% target for a while.
Might all of this eventually lead to hyperinflation? I am not in the hyperinflation camp. But if that’s the ultimate endgame of Modern Monetary Theory (MMT), then all bets are off.
Bonds IV: The Dollar Vigilantes. Of course, the death of the Bond Vigilantes could lead to the emergence of other vigilantes in the financial markets. The Dow Vigilantes got what they wanted in response to the freefall in stock prices from February 19 through March 23. They got QE4Ever plus the CARES Act. The result has been trillions of dollars printed and spent by Fed Chair Jerome Powell and Treasury Secretary Steven Mnuchin.
The Gold Vigilantes are certainly expressing their fear and loathing of this unholy alliance between fiscal and monetary policies. But they don’t have the kind of power that the Bond Vigilantes once had to rein in policy excesses. The only market players left with any power are the Dollar Vigilantes. They have lots of fear and loathing of MMT and can do something about it.
They can devalue the dollar relative to other currencies, thus putting upward pressure on import prices, which could revive inflation. Even the Wizards of MMT acknowledge that they should at least think about tapping on the brakes if inflation makes a comeback.