Traders work on the floor of the New York Stock Exchange on May 3, in New York City.Spencer Platt/Getty Images
There is a puzzle in financial markets. At the heart of it is a simple question: Where the heck are the bond vigilantes?
People of a certain age will remember the vigilantes. Back in the 1990s, that was the label we used to describe big bond buyers – pension funds, mutual funds and the like.
We called them vigilantes because we assumed these large institutional investors would crack down ruthlessly on any government that ran persistently big deficits by demanding it pay much higher interest rates. Those high interest rates would then make borrowing so painful that the wayward government would be forced to hammer its deficit back into line.
The bond vigilantes were reputed to be so powerful that James Carville, an adviser to then U.S. president Bill Clinton, famously joked that he no longer dreamed about being reincarnated as the pope or the president or a baseball slugger. Nope, he now wanted to come back as the bond market, because then “you can intimidate anyone.”
The bond vigilantes made for great headlines. However, it’s not clear they were ever as powerful as they were popularly believed to be. And right now, they’re missing in action, especially when it comes to the world’s most notorious spendthrift, the United States.
Washington has been running up massive debt in recent years, partly as a result of Trump-era tax cuts, partly as a result of pandemic spending and partly as a result of the Biden administration’s lavish incentives for everything from green energy to microchip manufacturing.
The non-partisan Congressional Budget Office estimates the U.S. federal deficit next year will stand at an alarming 6.1 per cent of gross domestic product. The International Monetary Fund thinks the gap will be even larger – around 7.1 per cent of GDP.
Whichever number you prefer, the projected fiscal shortfall is far, far higher than is internationally typical. The IMF expects other advanced economies to run deficits next year of only around 2 per cent of GDP. (The projected Canadian deficit ticks in even lower, at under 1 per cent.)
The current U.S. deficit towers over what is historically usual. In the past, the only times that the U.S. ran deficits of this magnitude were during wars, pandemics or financial crises. Fiscal stimulus of the current size is unprecedented at a time like now, when U.S. unemployment is low and the economy is growing at a decent pace.
But maybe that has things backward. If you’re looking for a simple explanation of why the U.S. and global economies have been so resilient over the past year, the most obvious explanation is that Washington has been footing the bill for the good times.
How long can this go on? Nobody is sure, but probably not forever. “In the long run, the U.S. is on an unsustainable fiscal path,” Federal Reserve Chair Jerome Powell warned in February. This past month, the IMF declared that massive U.S. fiscal deficits have stoked inflation and pose “significant risks” for the global economy.
Yet bond markets seem unconcerned. Yes, the yield on the U.S. 10-year Treasury bond has climbed to around 4.5 per cent, up from around 3 per cent in 2018, but the increased yield mainly reflects the recent bout of inflation. Most forecasters expect yields to ease over the coming couple of years as inflation fades.
These forecasters may be assuming that Washington has more room to run big deficits that any of us thought possible back in the 1990s. They can point to Japan, which has done all right in recent years despite carrying a debt-to-GDP load twice as large as that in the U.S.
Or maybe the market complacency has more to do with the widespread belief that interest rates will inevitably head lower because of aging populations and other structural factors. After all, interest rates fell steadily for 40 years before the recent spike in inflation. Perhaps that trend toward falling rates will reassert itself.
Or maybe bond vigilantes are missing in action because they are assuming that lawmakers will eventually get around to patching the U.S.’s gaping budget hole. Researchers at the Penn Wharton Budget Model at the University of Pennsylvania argue that financial markets are “effectively betting that future fiscal policy will provide substantial corrective measures ahead of time.”
The problem with these rationales for big deficits is that none of them seem to fit the U.S. situation exactly.
What, me worry?
If current policies are maintained, U.S. government debt will soar
over the next couple of decades, taking the world's leading econ-
omy to levels of indebtedness it has never before experienced.
(U.S. federal debt held by public as percentage
of gross domestic product)
200%
CBO estimates
180
160
140
120
100
80
60
40
20
0
1790
1820
1851
1882
1910
1941
1971
2002
2032
the globe and mail, Source: Torsten Slok, chief economist, Apollo
What, me worry?
If current policies are maintained, U.S. government debt will soar
over the next couple of decades, taking the world's leading econ-
omy to levels of indebtedness it has never before experienced.
(U.S. federal debt held by public as percentage
of gross domestic product)
200%
CBO estimates
180
160
140
120
100
80
60
40
20
0
1790
1820
1851
1882
1910
1941
1971
2002
2032
the globe and mail, Source: Torsten Slok, chief economist, Apollo
What, me worry?
If current policies are maintained, U.S. government debt will soar over the next couple of decades,
taking the world's leading economy to levels of indebtedness it has never before experienced.
(U.S. federal debt held by public as percentage of gross domestic product)
200%
CBO estimates
180
160
140
120
100
80
60
40
20
0
1790
1820
1851
1882
1910
1941
1971
2002
2032
the globe and mail, Source: Torsten Slok, chief economist, Apollo
Japan, for instance, has a much higher household savings rate than the U.S., which makes it easier to absorb large levels of government debt.
How about that long-term trend toward lower interest rates? There are good reasons to doubt it will continue, according to a recent presentation by Harvard economist Jeremy Stein that concluded the driving forces behind interest rates remain “a deep mystery.”
Finally, the notion that future policy makers will come to the rescue seems unrealistic, at least in the next few years. Neither free-spending Joe Biden nor tax-cutting Donald Trump is likely to rush to cut the deficit, no matter who gets elected in November.
All of this suggests that the debt vigilantes may be ready to stage a comeback. If you’re betting on a quick and decisive fall in interest rates, it’s worth pondering the possibility that rates will remain higher for much longer than you think.
Ian McGugan