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

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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  1. That’s alot of power. And is the number one reason why they Fed should be and WILL be eventually abolished.

  2. Happy Holidays Cullen. A quick question – have you ever shorted Treasuries or do you only play long/cash side?

  3. Will be interesting to see what happens when a Treasury Algo goes on a flash crash vigilante rampage.

  4. There’s a pretty extreme logical fallacy to this argument, which you’ve never really addressed. What happens if inflation hits (pick your number); say 7%. At this point, for all practical purposes the Fed starts to lose control over the bond market – market forces become more important. Sure, the Fed could theoretically come in and try to enforce a yield of x (even 0), but negative real rates would only stoke further inflation once the multiplier is functioning normally, there isn’t any large deleveraging force etc etc. So, a lot of these “Fed controls rates” arguments apply largely to low inflation periods; inflation always has and always will make monetary outcomes less of a central bank monopoly. And in that sense, future inflation remains a genuine problem.

  5. We don’t have to answer that question, but we do have to ask what happens if it does.
    Because any system has to be robust it has to function if unexpected events happen.
    For example, back in 2007, if you asked the question, ‘What if home prices fall,’ people answered that question by saying that home rates wouldn’t fall, which wasn’t addressing the critical question.

    So I’m with Delta here. Even if the Fed can control rates, doubtful it can control inflation.

  6. No, you ABSOLUTELY do have to answer that question. Otherwise, you’re conveniently skipping the most important variable in the equation.

  7. Then your system is not robust.
    You’re no different than the engineers who designed the Challenger and said it wouldn’t fail.
    Your equations a) can’t possibly include all variables and their values and b) you can’t be 100 percent confident in your understanding of all the variables.

  8. It’s not about my system. It’s about creating realistic scenarios. Why will inflation rise to 7%? Most likely because growth has surged and unemployment has declined. Min which case your whole scenario is based on a false premise and therefore not a realistic hypothetical….

  9. It really doesn’t matter if it’s not ‘realistic’ in your view. If we have a system that breaks down if something unrealistic happens, then we have a poor system.
    For example, it’s highly unrealistic that my house will burn down, but it would be foolish for me not to be able to answer the question: What if the house burns down?
    We can only guess at what will cause future inflation, or when it will happen, or what form it will take.
    But we do know that if happens repeatedly for different reasons and in different forms.
    I turn it back to you: Your assumption that inflation is unlikely is in itself a false premise.
    I suspect you hold that assumption because you don’t have an answer for it.

  10. I never said inflation was “unlikely”. I’ve actually stated the scenarios that will cause rates to rise because I’ve worked through the actual scenarios in realistic form. You, on the other hand, just skip to part of the story where the house burns down and say “who cares why the fire started?” Of course, if you told a judge that he’d tell you get out of his courtroom. If you told the home owner that he’d probably kick you in the shin. You’re just ignoring the most important piece of the puzzle because it’s an inconvenient piece for you to have to work through (because it most likely ruins your theory). I’ve actually gone through and explained the likely unfolding of such scenarios. See here:

  11. Couldn’t agree more. The Fed can’t set fundamentals, and if it attempts to act otherwise it can lead to economic dislocation.

    Buying bonds at negative real interest rates isn’t much different than over-pricing the s&p. My guess is that educated buyers would be reluctant to own equities in that theoretical environment as well, even as being outright short equities would be dangerous since the Fed has a lot of buying power.

    The question is, can the collective market overpower the Fed? In real fundamental terms I think the answer has to be yes. The market will flee to the safety of investments that are priced to give real return based on the true fundamentals of the economy. Bond Vigilantes are the personification of this dynamic. The Fed is powerful, but the market is more powerful.

  12. Some would argue that inflation is tied more to fiscal policy rather than monetary policy. It results from unproductive government spending (do we have any of that in the USA?) more so than from “money printing”. When (not if) that happens, the Fed may have the ability, but not the will, to smack down the bond traders.

  13. Do you not see the point I am making?
    My house is unlikely to burn down; however, I have systems in place to deal with that.
    On a personal level, I have homeowners insurance. I don’t leave flammables in the basemen. On a civic level, my town has a fire department.
    My ‘theory’ is that after having lived through a housing market crash and a stock market collapse that experts assured me could not happen, I am not going to accept your bland assurances that inflation won’t upset the bond market.

  14. Don’t forget the accidental vigilantes. Tsys are very liquid and daily volumes are huge; but net exposure changes are finite, and leveraged players caught on the wrong side can create dislocations. Look at forex markets and how volatile they have been in the last five years; truly astonishing.

  15. BTW don’t forget the Republicans (aka the bond vigilante party). More then enough times in recent history, people have bitten off their own noses to spite their face. Irrational, yes; very possible, yes.

  16. I’m still scratching my head for the actual answer to my question! And on a more philosophical basis, I certainly agree with Johnny, who seems to be echoing the Taleb argument – I want to live in a world with robust systems; one where the consequences of being wrong (human fallibility) are limited. Not a system where someone tells me the ONLY way you can have high inflation is through robust growth, draws up a scenario of hopefuls only to realize he was wrong and then tells me he regrets to inform me the whole damn system is burning down (Greenspan, anyone?!). Robust systems aren’t built on being right, they’re built on limited consequences of being wrong.

  17. Goodness! Cullen, you are Aesop of modern finance! Dog on a leash… it is better than “green shoots”!
    But take a long-term view. Just disregard all these little jerks. It started with pretty long leash 30 years ago. Then, gradually, the dog was getting closer and closer to the leg. Now, it sits literally on a shoe (or is it a boot?). If the fed moves the leash even closer, the dog will be hanging in the air… The poor beast would suffocate! What’s then? The fed will go and buy itself another one??? Or the leash would break and the dog runs loose??? That’s the question!

  18. Well, let me answer this one.
    The government, God bless it, adopts new infrastructure super investment program – to replace every existing bridge in the country, and to build super magnetic railway from NYC to Santa Barbara, CA. Obviously, the bonds are issued to finance it. Everybody gots employed as a result. In addition, everybody involved gets government pension (defined benefit, of cause), and full coverage healthcare insurance.
    How’s that for a start?

  19. I’m keeping a close eye on the development of treasury bonds on one hand and corporate and high yield bonds on the other one.
    The two could diverge though the only explanation I can find is that the FED keeps buying Treasury bonds and keeps interest artificially low while private bonds are submitted to market circumstances.

  20. how about because there is a massive disruption in the energy and food supplies due to global warming/war/terrorism/tsumanis/earthquakes/whatever causing commodities prices to spike and subside violently for prolonged periods of time

  21. krugman calls them vigilantes because he associates them with the forex vigilantes that would attack and destabilize the currency pegs of developing countries back in the 70s, 80s and 90s and they’re invisible because hard money crazies who don’t understand that these traders can’t exist in countries that control their own currencies – USA, Japan, etc. – are convinced they’re real and despite at least 4 years now of evidence to the contrary, they cannot be persuaded otherwise. krugman doesn’t mean invisible in the sense that you can’t see them but they’re there, he’s literally making fun of people.