With federal spending on the loose, are bond vigilantes set to make a comeback?
By Sunny Oh
Rising deficit raises the risk that 'bond vigilantes make an unwelcome return'
Budget deficits are set to explode after President Donald Trump signed off on a fresh deal Wednesday that will pump hundreds of billions more dollars into an economy many see near full capacity.
"While that will mean 2018 is a very strong year for economic growth, it will add to the rebound in inflation already underway," said analysts at Capital Economics.
That could set the stage for so-called bond vigilantes to punish the U.S.'s fiscal profligacy by pushing up interest rates until it began to take a toll on growth and volatile financial markets.
"With the fiscal deficit heading beyond 5% of GDP, it raises the risks that "bond vigilantes" make an unwelcome return," they said.
The deal would lift spending caps by around $300 billion over the next two years, which were limited by the 2011 Budget Control Act intended to rein in fiscal profligacy. Combined with a $1.5 trillion tax cut passed in December, the deficit is now on track to reach 5% of GDP by the end of 2019, according to Capital Economics' estimates.
The term bond vigilantes is a throwback to an era when loose-spending governments would incur the wrath of the bond market, fearful that higher inflation would erode the value of fixed-income payments. Yields for government paper would then shoot up, driving up borrowing costs, tightening financial conditions, and throwing general panic into broader financial markets.
President Bill Clinton's administration learned the hard way that strong growth and higher inflation would take a backlash from bond investors. During the 1994 "bond market massacre", former Federal Reserve Chairman Alan Greenspan doubled interest rates to 6% from 3% in an attempt to slow the economy's breakneck momentum. In response, the 10-year Treasury note yield reached a height of 7.94%. Bond prices fall when yields rise.
That prompted James Carville, who at the time served as Clinton's political adviser, to remark, "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate anybody."
But since the 2008 financial crisis, the term has fallen out of use after the U.S. deployed Keynesian fiscal expansionary policies to pull the economy back from the brink, while inflation remained subdued. Without the threat of raging price pressures, bond yields travelled lower until it hit an all-time low of 1.27% in 2016.
See: Should the bond market freak out about a $1.1 trillion deficit? (http://www.marketwatch.com/story/should-the-bond-market-freak-out-about-a-11-trillion-deficit-2018-02-08)
-Sunny Oh; 415-439-6400; AskNewswires@dowjones.com
(END) Dow Jones Newswires
02-09-18 1440ETCopyright (c) 2018 Dow Jones & Company, Inc.