About Those “Invisible Bond Vigilantes”

* This one’s long, but important in my opinion as it will help the reader better understand many different concepts….

In a post last week Paul Krugman provided a simple model explaining why fears over bond vigilantes in the USA was wrong.   He ended with this:

“If there’s something more going on here, I’d like to hear about it.”

I’ve had a lot to say about this for years so I figured I’d chime.

Bond traders are a simple species.  If you offer them a low risk arbitrage opportunity they’ll almost always jump on it.   But there’s an intricate dance that occurs in US government bond markets.   Before we dive into the details, it’s important to understand why the US government even borrows money in the first place.  After all, the government could theoretically just print up its own money and spend it (and the USA has at times done precisely that).  Of course, that’s not what the US government does.  Instead, the US government outsources the creation of money to its banking system (the private sector) in a design structure that is in keeping with a capitalist economy.  The US money supply is essentially privatized to an oligopoly of private entities in an attempt to create a competitive market based (demand driven) money system.  So the government makes itself a user of  money in this regard.  It MUST obtain funds from the private sector before it can spend. It achieves this via taxation and bond sales.  In a representative republic like the USA we essentially choose to move resources to the public domain for public purpose.

Although the Treasury must obtain funds before it can credit bank accounts there is really never a concern about this being achievable.  The government will either tax, sell bonds or, in an absolutely worst case scenario, use its central bank to create money.  In this regard, the government imposes its powers as a possible currency issuer.  As I often say, there’s no such thing as the US government “running out of money” even in a worst case scenario like hyperinflation.  So all the fears about the USA having a solvency crisis are unfounded.  But that doesn’t mean the USA can’t have a currency crisis resulting from hyperinflation.  As I’ve previously explained in my reasoning as to why hyperinflation is an extremely low probability event in the USA, hyperinflation is usually the result of extremely rare exogenous events.  This usually involves a collapse in production, loss of war, loss of currency sovereignty, etc.

On the bond side, the US government has a very specific design structure.  First of all, Primary Dealers are required to bid at Treasury Bond auctions and must maintain reasonable markets in US government debt.  That’s just part of the deal when working with the government (which is lucrative for the banks in various ways).  As I often point out, you’ll notice in the details of the auction results, that the auctions seem predetermined.  That’s because they essentially are.  The Fed, Treasury and Dealers all work together in close unison to ensure that auctions can be filled.  The Dealers, being required to bid, will always be able to take down the entire auction (and can usually take down 2X the auction).  Again, that’s by design.  If you check the data you’ll see this is just about always the case.  It doesn’t matter how much China is buying or how much individuals are buying via Treasury Direct.  Auctions are designed not to fail.  So they don’t.

The banks are happy to make markets for the government as long as they can keep their books hedged, scrape the fees and on-sell most of their inventory.  That is, banks are engaging in a relatively low-risk game here and in exchange the government gets to maintain a private competitive monetary system and obtain the funding current monetary design requires it to obtain.

But the real question is – who’e controlling price here?  Who sets yields on government debt?  The bond vigilantes or the government?  As I’ve previously mentioned, the government cannot “run out of money”.  This is very important.  Unlike Greece, the USA has a cohesive banking system, Treasury and Fed.  In essence, the banks agree to buy for the Treasury and the government agrees to guarantee solvency (always deliver payment).  So traders in US government bonds don’t worry about getting 100 cents on the dollar when the bonds mature – seasoned fixed income traders just know you don’t fight the Fed in this regard.  So the banks just have to manage their risks flipping the bonds for a profit (either scraping fees or arbing the spread on their books) and managing their inventory in a manner that reduces their exposure to the real risk of owning this paper – purchasing power loss.

In a low or falling inflation environment this is a low risk game that the banks are happy to engage in.  It becomes trickier as inflation rises.    One could easily imagine a scenario in which inflation is raging out of control (for whatever reason) and the banks can’t on-sell their inventory or adequately manage the risks on their books.  The Fed could buy, but true monetization has already set-in which collapses the currency and spells the endgame for the monetary regime.

Inflation becomes problematic when it outstrips productive capacity.  But this works two ways.  In a healthy economy inflation outstrips productive capacity when output is high, unemployment is low, etc.  This is bad, but “bad” in the same way that eating chocolate cake is “bad”.  Inflation can also become problematic in a world of collapsing production (think Weimar, Zimbabwe).   This is a very different scenario and a far more dangerous scenario.  In this scenario inflation outstrips output and we enter a classic case of too much money chasing too few goods.  After all, currency demand is ultimately a function of the quality of the goods and services this tool of exchange offers you the possibility to purchase.  The value of the currency and the bonds the government sells are largely derived from this underlying output.  So, with collapsing output there is little to no reason to hold either currency or bonds.

So again, who’s controlling bond yields?  The government or the bond market?  The analogy I often use here is a person walking a dog.  Think of the bond market like an untrained dog leading the person.  The Fed is akin to the person while the bond market is akin to the dog.  The bond market will always try to lead the Fed (traders front-run, that’s what they do).  But the Fed, as the supplier of reserves to the banking system can ALWAYS control the price of bonds.  It can literally set the price of US government bonds (on any part of the curve) at whatever price it wants.  But Fed policy is ultimately a function of their expectations of the future economic environment.  If the Fed expects the economy to remain weak they’ll try to stimulate the economy by keeping rates low.  The bond market can try to lead the Fed, but can’t set price.  So the bond market ultimately has to adhere to the Fed (who adheres to the economy).  So this dance is more complex than the one sided debate most of monetary theory tries to imply.

But what about that collapsing output scenario?  What happens then?  What does the Fed do?  In this scenario I would argue our dog resembles something more like a tiger.  The Fed suddenly has very little control.  Yes, the Fed could theoretically still pin rates at zero, but they would never do this because interest rates and inflation would be soaring.  In an attempt to get control of the economy they would try to set rates high.  But the banks would already be front running the Fed selling bonds like a wild tiger pulling a person around at will.  The Fed can set rates, but the government can’t set the economy.

So, who controls price?  Bond vigilantes or the Fed?  The answer is “it depends”.  99% of the time the Fed controls price.  But it’s that 1% of the time that the Fed loses control that ends up destroying 100% of the economy.  But most interestingly, it’s really neither the Fed nor the bond market who controls the value of bonds or currency.  They’re just secondary players in a much bigger game where the outcome is decided by the quality of the output society creates and the willingness of the currency users to use this tool of exchange to obtain that output.