THE BOND VIGILANTES ARE COMING!

I see some chatter in different circles about rising interest rates and how the bond vigilantes are just one step away from throwing the US economy into the dumpster because our debt situation is becoming increasingly “unsustainable”.  It’s all nonsense.  First of all, I want to put the recent rise in yields into perspective.  I’ve taken the 30 year bond yield and blown up an image of the recent rise in rates.  My trusty computer magnifying glass can barely see the ferocity with which the bond vigilantes are attacking our bond market (see figure 1 below).

Of course, the truth is that the USA is an autonomous issuer of its own currency.  That means it can never “run out” of money (see here if you’re getting confused already).  This is very different than what’s going on in Europe where each country is analogous to a state in the USA and a currency user.  The difference is critical when understanding the economy and the markets.  Because there is no solvency risk in the USA the bond markets are almost entirely controlled by the Fed (private credit markets are different).  That’s right.  James Carville was wrong – when you come back you want to come back as the Federal Reserve, not the bond market!   Of course, we could print so much money (since we can’t run out of money we can certainly issue too much of it!) that inflation becomes wildly out of control and our currency collapses to nothing and causes the US to become a third world country, but that’s a very different phenomenon than the USA becoming Greece who can literally run out of Euro….

In short, the bond vigilantes aren’t coming.  The thought of bond vigilantes existing in the USA is like believing there’s a boogeyman underneath your bed.  If rates rise it will be because the economy strengthens or inflation gets uncomfortably high (a scenario which will likely accompany stronger economic growth OR a spike in oil prices which will likely be followed promptly by recession).  Either way, don’t fear the bond vigilantes.  As I’ve said since the beginning of the year, bonds are overpriced and yields are likely to move higher from here, but that’s not because of mythical bond vigilantes.  It’s just the natural cyclicality of the market and the Fed letting the dog leash out a little bit.  If rates rise too much the Fed will yank that dog back into place.  And if the recovery becomes a boom then the Fed will likely raise rates forecasting to the bond market that they can take the leash out a little further….

(Figure 1 – those vicious bond vigilantes!)

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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Comments

  1. The Europeans really can’t run out of money, either, as they have decided to create more Euros to cover their deficits.
    We’ll see how it works out; but don’t think we should be sneering at the risks we face.

    • Individual European countries do not have the power to create Euros and thus can run out of money. They rely on the goodness of others to give them money.

      USA is different, as is the UK, Japan, Australia – anyone with a floating fiat currency system. The governments are not restrained in any way in their ability to issue money and thus can’t run out of it.

      USA bond yields will rise on the expectation that the FED will increase interest rates one day – that’s what’s happening right now.

      • The ECB can print as much as it wants, but there is a distributional issue in the EU. That printing does not necessarily help every State equally. (I call them States and not Countries because the EU States are not really Sovereign.) The ECB could print 1000T Euros and Greece is still BK. Unless they create a real EU Federal Government, this issue does not go away.

        There may be no “bond vigilantes” in the US Treasury market, but there certainly could be in the State and Muni markets if the USA enters another recession. I wouldn’t want to own Detroit, Illionis, or Michigan bonds, but I would gladly own Fairfax County VA bonds (and do).

        • Well, the thing in Europe is that growth will remain weak because of the austerity, but the solvency issue is off the table so long as the ECB says so. Who knows how long this charade can last though?

          • Can’t wait to see how they will solve the TARGET 2 equation…

            TARGET 2: Trans-European Automated Real-time Gross settlement Express Transfer System

          • correct me if i’m wrong, but the ECB is NOT creating new money. The creation is horizontal, not vertical, because the money is not being spent into the eurozone, but rather “lent” at 1%. There is still a claim on future earnings with this scenario. Yes, the can is kicked further down the road, as long as the ECB is willing to lend at 1%, but the solvency issue is delayed, not solved…

            As an aside, I notice an article saying the LTRO may be helpful in allowing banks to make more auto loans, so Volkswagen is pushing ahead with rolling out a new line… If there are people not facing austerity, this could be helpful to eurozone…

            rhp

            • Yes, the ECB has convinced the banks to fund the govts while convincing the govts to impose austerity. It’s a ponzi scheme of sorts with the ECB playing the cheap funding source. It can’t and won’t last because it won’t fix the actual problem. I just don’t know how this doesn’t flare up again and again until eventually the banks throw up on themselves and force the govt’s of Germany and France to take bold action to stop a banking crisis.

              • quite right CR- the LTRO is a ponzi scheme. they lend to the banks so the banks can buy the “sovereign” bonds, which the ECB takes back as collateral for the loan. the banks skim the difference in coupon to LTRO rate and a little boost from bond price appreciation as their “buying” pushes down rates.

                Then, the “sovereigns” can issue more debt and say “gee, look, our rates are declining and people are buying our paper, we must be in great shape!”

                Oh, and the banks can also slosh around some cash into commodities and stocks to keep the asset bubbles going too…

                Ponzi would be proud at the artform he invented the world has so embraced.

              • The bold action to stop the banking crisis is to remove the credit banks – it will not happen of course we are even more banked then yee guys.

      • How is that the ECB can “print” but that the Fed cannot, if they are both central banks?

        • Each nation technically has its own central bank which the ECB is sort of the overseer of. If the national CB prints Euro to help the nation conduct govt policy then that adds net financial assets. The current arrangement is deranged though. The govt’s are being forced to be austere and the ECB is supplying loans to banks to fund the govt spending and avoid insolvency. The ECB is acting like a foreign central bank. Not the central bank of each nation. Sort of reminds me of what the IMF does. It’s usually a disaster because it wrecks the domestic economy.

          • Frankly, the IMF process is a lot better because it allows countries to devalue their way back into competitiveness. And the track record isn’t half bad, if you ask me. If the Greeks could devalue AND adopt Troika measures, they might actually become competitive. But, the single currency stands in the way.

  2. Oh, yes the bond vigilantes WILL show up and the FED can’t do a thing about it. In fact the FED only makes things worse. See what happened when the PBOC pumped about $ 1 trillion into the chinese economy in late 2008, 2009, 2010 and 2011.

    Anyone who noticed what happened in late 2010 knows that the FED can’t control interest rates. The FED bought about $ 600 billion worth of T-bonds and in spite of that interest rates ($TYX, $TNX) went up. Remember ???

    Perhaps this is the impact of QE3 ??? But more QE means that interest rates WILL go lower.

      • 1. I expect rates to go much lower to say 1.0%, 0.5% and perhaps even 0.2%. But eventually rates WILL go higher !!!
        2. A second thing is REAL rates. Nominal rates can go to say 3% but when e.g. the CRB index goes through the floor (like in 2008) then REAL rates could shoot up to say 8%, 10% or 12%. And a REAL rate of 12% is toxic for ANY society. Greece, UK, Germany or US.
        3. Suppose all oil is priced in any other currency than the USD today, then US interest rates WILL go through the roof, starting tomorrow.

    • Yet you don’t seem to have noticed that sharp drop in yields in 2011. That was Operation Twist, when the Fed decided to target yields. When it wants lower prices, it gets lower prices.

  3. There is an impact though – longer tenor USTs obviously have a much higher duration and MTM can be painful – especially when the carry is so low at these levels.

    • That’s assuming rates rise substantially, portfolios are locked in at low yields and other assets aren’t owned to diversify. But yes, if you own a billion dollars of 30 yr USTs at a yield of 1.8% then you’re biting your nails for the next 29.5 years…. But like most primary dealers and big banks you’re likely laddering over or hedging these positions all the time….

  4. ” As I’ve said since the beginning of the year, bonds are overpriced and yields are likely to move higher from here”
    Did you place any trade based on this assumption?

  5. Cullen – at what point would you start betting on a reversal? Only when the Fed announces plans to raise rates?

  6. In the next Q&A I’ll try to remember my question about rate targeting. Anyway, yields going up still represents money fleeing tsy’s, right? I kicked myself for not watching the yields, but my first thought when I noticed last week is that there’s an asset flow from Tsy’s to equities. I knew I should’ve stuck to the “Sell in May” theme. I’ve had some expensive shorts.

      • Short answer yes, long answer it indirectly makes borrowing money more expensive by increasing the discount cost — no bank will risk lending money to Joe for 3% when the Treasury will pay you 3% risk free.

        Since low rates are the only thing keeping housing from declining further, we’re basically assured that rates are going to stay at 0.25% until 2014 like the Fed says. The Fed presumably also needs to wait that long for commercial/residential ARM mortgages to get refinanced, consumer credit scores to recover, and to let inflation eat some of the cost of the outstanding debt.

  7. you said, “in the USA the bond markets are almost entirely controlled by the Fed.”

    you forgot to include equity markets too.

  8. I’m interested in Iceland’s discussion to give up their currency in favor of the Euro or Looney. It seems to me to be a no brainer — the Looney, but I would think they need to also become a Canadian province. Since Iceland is so vulnerable to bond vigilantes this seems to me to be an interesting question. What would MMR predict to be the best choice? http://www.icenews.is/index.php/2012/03/02/canada-ready-to-discuss-letting-iceland-use-its-dollar/ http://consultingbyrpm.com/blog/2011/11/krugman-promises-to-reconcile-himself-at-a-date-tbd.html

    • MMR says Iceland giving up monetary sovereignty is a disaster waiting to happen. It can’t devalue, can’t stimulate at need and ultimately can’t service its debts if it gets into trouble.

  9. The US is vastly outperforming Japan in deleveraging. They were slow and timid in fiscal and monetary policy. We weren’t.

    We have produced slow growth and inflation at the same time the private sector has shed debt, BUT once the private sector has healed the public sector must shrink debt relative to GDP. There is no way our 10yr can rise much further with all the debt still out there.

    With all of Japan’s public debt, their 10yr has stayed under 2% for 14 years. The last time the US gov had high debt comparable to today, the fed pegged rates at 2% for 15 years. Our 10yr might not stay low for 15 more years, but I am sure our government/fed will do everything they can to keep it low until both private and public debt/gdp are cut.

    From the WSJ, supposedly every 100 basis point rise in borrowing costs adds 1 trillion to new public debt. In the next 3 years 5.6 trillion will need to be refinanced.

    As stated in previous comments, we also have consumer credit and housing’s dependency upon low rates.

    But….all of this pressure on the fed to keep rates low could be overpowered by one segment of the population that is extremely angry…..savers. Watch out Ben. They’re coming for you!

    • But what power do savers have? The big money savers have the ear of politicians so have the feedback to inside info on S&P moves so they do not worry about 2-3% stuff.
      MOM and POP are in debt or just getting buy check to check plus the SNAP so where is this powerful savers group that you say is coming !!!

  10. Cullen said:

    “Of course, we could print so much money (since we can’t run out of money we can certainly issue too much of it!) that inflation becomes wildly out of control and our currency collapses to nothing and causes the US to become a third world country, but that’s a very different phenomenon than the USA becoming Greece who can literally run out of Euro….”

    The more you read the statement above, the more you understand that Cullen is coming to his senses. From MMT to MMR to Chicago School it is slowly getting there.
    What is the use of promoting a theory (printing ad infinitum) when you know it cant happen in reality?

    • Coming to my senses? That has been my position for years and years. It’s always about inflation. Never solvency. If you print too much you get inflation. But there’s no such thing as running out of money….

    • “The more you read the statement above, the more you understand that Cullen is coming to his senses. From MMT to MMR to Chicago School it is slowly getting there.”

      The Chicago School is pathetic. I saw it from the inside when I did my MBA work there. It’s purely political ideology wrapped in equations. And simple equations at that – the profs there aren’t smart enough to handle differential equations.

      As for Cullen’s positions – he’s been completely consistent since I started visiting this site many months ago.

  11. Hmmm, Mr Roche, I am noticing more and more of these sorts of comments.

    I like them a lot (why did I expect one of these after the comment though..;).

    ‘Of course, we could print so much money (since we can’t run out of money we can certainly issue too much of it!) that inflation becomes wildly out of control and our currency collapses to nothing and causes the US to become a third world country’

    You’re messing with my mind on purpose I think.

  12. This article would be even better if the increase in yields shows the corresponding % decline in the bond. That is what matters to investors – that is for every .1% yield rises – how much does the bond portfolio drop with an average maturity of say X years.

    And the other factor missing is what are the secondary benefits and costs of interest rates have on banking, corporations, government and consumer. This approach here is too focussed on governments that can tolerate drifting yields though other agents in the economy may not be as indifferent to yields changes.

    Just my thoughts on a more balanced in fair views, but the point is valid that the impact to the government is overstated by many.

  13. I guess the “”bond vigilantes”” did’t like the news about the scandalous behaviour of Goldman Sachs.