As the disaster that is Washington continues, the world needs bond vigilantes to bring the political class to its senses
Sadly thanks to the Federal Reserve’s endless QE, that restraint and imposed market discipline is no longer in place. And that is dangerous. Without the market check, Washington is risking ruin.
So how are these “bond vigilantes” and how do they impose discipline on the ruling classes? They are simply the mass of investors in government debt who by their actions force governments back to the financial straight and narrow. If they think a Nation is spending too much without enough taxation, resulting in excessive deficits and ballooning debt, they will demand a higher interest rate. That is basic finance; higher risk is compensated by a higher return. So as a Nation’s debt rises rapidly, the nation has to pay higher interest rates. So bond yields – borrowing costs – rise. And that is the restraint imposed upon governments – borrowing becomes more expensive the more fiscally irresponsible the government becomes. That is the check to stop politicians getting their country overly indebted.
And it is the same mechanism with irresponsible monetary policy too – a higher yield is required by investors to compensate for the loss in monetary value from inflation. So bond investors are really important for financially feckless nations, because they that drag the ruling classes back to sensible economic policies (by demanding higher interest rates).
But the problem is that the Federal Reserve is currently buying $85bn of bonds a month, manipulating America’s borrowing costs lower. The Fed is the biggest player in the markets and if it wants bond yields down then few will bet they will go up. Thus there is no corrective mechanism. Without the Fed’s QE, the current Washington fiasco would have increased America’s borrowing costs and that would have helped to force politicians back to the negotiating table. It now looks likely that the Fed didn’t taper in September as it was concerned about the impact the shutdown would have on the economy. It is also likely that with no non farm payrolls figure being released on Friday, the Fed will not taper in October either. Implicitly the Federal Reserve is bailing out the incompetency of Washington. The stick has been removed allowing the political class to play wild and threaten default.
The yield on the 10 year Treasury has barely moved this week at around to 2.6%, and still below the 3% level when QE was expected to taper. The US stock market is also supported by the Fed’s monetary support. The S&P500 initially completely ignored the shutdown even if it weakened later. However there is stress showing in the Credit Default Swap market – the cost of insuring US debt for default over the next year:
The Index of Fear, or SPX volatility has also increased to some extent, but not much, highlighting the protection afforded to the stock market of such easy monetary policy:
A big move in the CDS market or even slightly increased stock market volatility can be largely ignored by Washington. It does not have the impact of big falls in the stock market, the dollar or Treasuries.
One would have thought that bond vigilantes would be feted by electorates for keeping their governments on their financial tippy toes. But not so. The European press, for example, held bond investors partly to blame for forcing out the democratically elected Prime Minister Berlusconi from office in November 2011. But it was his failure to comply with ECB demands for austerity that resulted in his departure. The bond investors were just reacting to his incompetence.
The electorate has neither the expertise, interest or time to analyse their government’s finances. And yet it is ultimately the voting taxpayer who ends up paying for the financially reckless governments of the past. The job of keeping the political class on the financial straight and narrow is contracted out to the much more expert bond investors. Most fail to understand this.
My you tube video for this week is for all the underappreciated bond vigilantes out there:
The Animals: Don’t Let Me Be Misunderstood
“But I’m just a soul whose intentions are good, oh Lord please don’t let me be misunderstood…”
Although bond vigilantes (normally) punish incompetent governments, they do so to protect their investors, demanding a higher yield for greater risk. These bond vigilantes do not want to cause the downfall of governments, they react to what the politicians do and say. David Cameron may have hugged a hoody, but I tell you that taxpaying voters should cuddle a bond vigilante.
And of course this is not just the situation in the USA. The ECB’s OMT keeps the lid on borrowing costs in Italy and Spain, thereby reducing the fiscal pressure on those governments (and frankly who cares about breaking the rules of the Fiscal Compact?) And of course here in the UK, the Bank of England may have stopped gilt purchases but has said it will resurrect QE if necessary.
So going back to the top question “Where are the Bond Vigilantes when we need them?” The answer? To the detriment of all nations, they are cowed into submission by the central bankers.
The Federal Reserve is not doing Americans any favours by allowing Washington to continue its insanity.