Bond “Vigilantes”? More Like Bond Scavengers….

All this talk about “bond vigilantes” in recent days bothers me because it gets the operational realities wrong.  Some people think the vigilantes are just waiting to attack the US Treasury market.  Other people, like Paul Krugman, just think they’re “invisible”.  Invisible implies a certain sense of power that is temporarily gone.  It implies that they could one day appear out of nowhere.

This term is just as annoying as the “fiscal cliff” because it implies something that isn’t at all accurate.  The more accurate description is “bond scavengers”.  Bond traders don’t extract their pound of flesh from the US economy when the US government is a bad boy.  Bond traders try to front-run Fed policy and economic expectations in an attempt to generate a profit.  I describe this whole process like a person walking a dog through traffic.  The Fed is the person walking the dog.  The dog is the bond market.  And the traffic is the economy.

The Fed, could, theoretically, control the entire US government yield curve.  Yes, it could pin 10 year bonds at 0% if it wanted to.  And it would defend that rate with its bottomless pit of reserves and fixed income traders would be entirely powerless to move the rate.  Of course, the Fed doesn’t do that because it sets rates based on future economic expectations.  Keeping the long rate at 0% would be irrational, but don’t take that to mean the power isn’t there.

Like a person holding a leash, there is total control at the base of the leash and slightly less control at the end of the leash attached to the dog.  You can think of this like the yield curve in relationship to the Fed’s level of control.  When the Fed sees a stronger economy they forecast higher future rates which is the equivalent of letting the dog run out ahead.  And when the Fed sees the need for tighter policy they tighten the leash by yanking at the neck of the dog and pulling the leash in tight.  Bond traders can fight the Fed, but like good little doggies, they’re quick learners.  “Don’t fight the Fed” is any good fixed income trader’s motto.  But don’t get the order of control wrong here.  The Fed can smack bond traders down any time it wants.  Of course, what neither can control is the traffic….

Anyhow, I am really overkilling this point, but it’s an important one.  The word “vigilante” implies a sense of power that is simply not there.  Bond traders aren’t vigilantes.  They’re scavengers who front-run the Fed and hope to pick up the scraps left over from current economic conditions.

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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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