Return of the bond vigilantes: will inflation fears spoil the post-pandemic party?

The sell-off this week in government bonds reflects concerns that an economic boom will reignite inflationary pressures

Robin Wigglesworth, Joe Rennison, Eric Platt and Colby Smith

    © FT montage

Many eulogies have been written for the “bond vigilantes” that were once said to prowl global markets for spendthrift countries to bully into fiscal rectitude. But the vigilantes seem to have saddled up again.

The term was originally coined by former EF Hutton economist Edward Yardeni in the early 1980s to describe how bond sell-offs could force the hand of central banks or governments. The concept was later immortalised by James Carville, an aide to President Bill Clinton who in 1994 ruefully wished he could be reincarnated as the bond market so he could “intimidate everybody”.

For the past two decades there has been little sign of the vigilantes. Inflation remained quiescent globally, and a desperate hunger for returns eroded the discipline of many bond investors. Since the financial crisis, central banks have smothered fixed-income markets with a succession of vast quantitative easing programmes that neutered any would-be vigilantes.

‘Bond vigilantes’ was originally coined by economist Ed Yardeni in the 1980s to describe how bond sell-offs could force the hand of central banks or governments . . .  © Bloomberg

. . . a concept later immortalised by James Carville, former aide to President Bill Clinton, who said he wished to be reincarnated as the bond market so he could ‘intimidate everybody’ © Getty Images for Politicon

But 2021 has seen a disconcertingly swift and powerful bond market rout. The 10-year US Treasury yield — arguably the most important interest rate in the world as it influences prices in virtually every other corner of financial markets — jumped from under 1 per cent at the start of the year to over 1.6 per cent amid tumultuous trading.

As the pandemic starts to wane, many governments around the world have promised to “act big” to spur recovery and repair the economic scarring of the past year. But some analysts now believe the bond vigilantes are riding again — and could undermine the economic recovery and on unsettle booming financial markets.

“We’re in a brave new world of excesses in fiscal and monetary policy, and that’s where the bond vigilantes thrive,” Yardeni says. “It’s their job to bring law and order back to the economy when the central banks and the fiscal authorities are lawless. And that’s arguably what we’re seeing here.”

The central reason for the global bond sell-off is a positive one: although the economic scars from the Covid-19 pandemic remain significant, the combination of ample financial stimulus and pent-up demand being unleashed by the rollout of vaccines means that analysts are rushing to ratchet up their growth forecasts for 2021. Many now expect the biggest economic boom in generations.

However, some fear that this could finally reignite long-dormant inflationary pressures. Inflation is the nemesis of bonds, because it erodes the real value of the fixed interest rates that they pay. Central banks have vowed to stay their hand as long as unemployment remains elevated, but the deepening bond dive shows that markets are beginning to be sceptical of that promise.

A year ago, Italy abruptly quarantined 10 towns to limit the outbreak of a novel coronavirus, hammering home the global scale of the threat

For now, most analysts and investors stress that even if inflation is likely to accelerate in 2021, it is likely to prove a fleeting phenomenon, and not something that will pose a serious, longer-term challenge to fixed income markets. 

While the recent rise in yields has been notable for its speed and power, bond yields remain astonishingly low by historical standards, and some investors now reckon they have moved too far, too fast and are likely to stabilise soon.

Nonetheless, others worry that with investors so accustomed to low bond yields, even a modest rise could upset the dominant fuel of the “everything rally” across markets. Stock markets have already started trembling at the recent uptick, and bond market sell-offs have a nasty way of revealing unexpected faultlines.

“We will certainly get an overshoot. The question is whether the market structure is now vulnerable enough that you’re going to have that echoed and exacerbated in ways we’ve not seen previously,” says Joyce Chang, chair of global research at JPMorgan.

The post-Covid economy

Almost exactly a year ago this weekend, Italy abruptly quarantined 10 towns to limit the outbreak of a novel coronavirus originating in China. The move hammered home that a pandemic was a serious, global threat, and turned simmering nervousness into a full-blown financial market meltdown by March.

Highly rated government bonds are the investment world’s panic room, a safe space where everyone from sovereign wealth funds and insurance companies to money managers and individual savers instinctively head to when times are tough. 

That causes their prices to rise, and pushes down their effective interest rate, or yield.

When Covid-19 rattled markets, the bond yields of countries from the US to Finland, Germany to Australia, France to the UK, plunged to fresh lows that in some cases made even past records seem dowdy. 

But since last summer, sovereign bond yields have been creeping steadily up.

The first big impetus came from the emergence of several highly effective vaccines last November, which meant investors could finally start to contemplate what a post-Covid global economy might look like in 2021. 

Then Democrats won control of the US Senate in January, making possible another big stimulus package that would swell the deficit but hopefully ensure a powerful economic upswing that balms some of the scars left by the pandemic.

Dan Ivascyn of Pimco is sceptical that inflation will take off but stresses that the economic environment is unique © Bloomberg

Joyce Chang of JPMorgan says the question is ‘whether the market structure is now vulnerable enough that you’re going to have that echoed in ways we’ve not seen previously’ © Bloomberg

JPMorgan Asset Management estimates that the combined central bank and government stimulus measures already totalled $20tn last year, or more than a fifth of global economic output. 

Now some economists fret that the additional $1.9tn spending package being readied by President Joe Biden’s administration may overheat the US economy.

Pimco, a bond investment group, expects that this additional Covid-19 relief package will boost the US budget deficit to a record $3.5tn in 2021, and lift the annual growth rate to over 7 per cent. That is a pace that has only been hit in three quarters since the 1950s — all of them in the inflationary 1970s and 1980s, Pimco notes.

Dan Ivascyn, Pimco’s chief investment officer, is sceptical that inflation will take off, but stresses that the economic environment is unique. 

“There’s a lot of stimulus at a time when the economy is starting to show some strength. And that understandably makes bond markets nervous,” he says.

Some economists predict a shortlived inflation burst as spending on services and restaurants surges when lockdowns end © Bloomberg

Dan Fuss, vice-chair at US asset manager Loomis Sayles, has seen many economic cycles through his six-decade career as a bond investor, and he is worried that history shows that the scale of the stimulus will inevitably reignite inflation. 

“I can almost hear Milton Friedman shouting ‘look out here it comes’,” he says. “Can it work out differently? Of course. Is that the way to bet? No, it’s not.”

Notably, the primary drivers of the bond market sell-off have subtly shifted in recent weeks. 

While the increase in yields since November was primarily powered by rising inflation expectations, the latest moves have largely come from investors starting to price in central banks tightening monetary policy more quickly than they have previously indicated.

That is particularly dangerous for other financial markets, as sub-zero “real”, inflation-adjusted yields have been the dominant reason why investors have felt comfortable paying more for a range of other financial securities than they have in the past. 

“You’ve built these mini pockets of speculative excess that arguably could be subject to more profit-taking if this continues,” says Liz Ann Sonders, chief investment strategist at Charles Schwab.

Underscoring this tense relationship, equity markets have recently seesawed nervously on days when yields have climbed higher, even though the fundamental reason is rising economic optimism. 

More than $800bn has been sliced off valuations of the companies that make up the Nasdaq Composite over the past two weeks.

Although most real yields remain negative across most major government bond markets, Matt King, a Citi strategist, notes that the threshold for rising real yields to trigger sell-offs across markets seems to be falling. 

“The more dovish central banks are, the more money they pump into the system, the more dependent markets become on that money to maintain high valuations,” says King.

Reacting to turbulence

Nonetheless, most investors and analysts are sceptical that a new era of inflation is dawning given the scale of the economic devastation left in the wake of the pandemic, and longer-term deflationary forces like ageing demographics, global supply chains and technological innovation.

Seth Carpenter, chief US economist at UBS, also envisages only a shortlived inflation burst. Spending on services will surge as lockdowns end, yet spending on goods will probably fall as people choose to visit restaurants and do less shopping online. 

Furthermore, much of the additional stimulus cash coming into households will go to repaying overdue debts, Carpenter says.

Continuing deflationary forces like ageing demographics and global supply chains cast doubt over predictions of a new era of inflation © Bloomberg

Central bankers have this week been at pains to stress that they will not tighten policy to stem an expected inflation spike this year, and that they are keeping a close eye on the bond market reversal. 

The Reserve Bank of Australia has already restarted its quantitative easing programme, and some analysts expect that others may take action to ensure that the fixed income rout doesn’t deepen further into something more destructive.

The dramatic shifts this week may precipitate action sooner rather than later, argues Scott Minerd, global chief investment officer of Guggenheim Partners. 

“This volatility is starting to have a real impact in financial markets and given the excessive amount of leverage in the system . . . we are running the risk that we are going to have financial instability,” he says. 

“Ultimately the Federal Reserve may have to become even more aggressive to keep markets from becoming more chaotic.”

However, the bond vigilantes’ comeback tour may be a shortlived one. 

Robert Michele, chief investment officer at JPMorgan Asset Management, points out that the Fed is still buying $120bn of bonds a month. 

Add in the purchases of other central banks and there is a global tsunami of money that will eventually manage to quell the turbulence, he expects.

“At some point — and it may be now — there will be a capitulation, yields will have gotten too high, and the relentless weight of the bond purchases from the central banks will stabilise the market,” he says. 

“The asset purchases are relentless. You can’t fight that.”

The Fed must avoid a repeat of the March Treasuries mystery

Emergency measures unblocked the bond markets in 2020, but there is a risk of another crisis

Gillian Tett

© Efi Chalikopoulou

This month, a “whodunnit” — or “what-did-it” — mystery hangs over markets. 

No, this is not about gyrations in bitcoin prices or GameStop shares.

Instead, the issue is the $21tn US Treasuries sector. 

In March 2020, as Covid-19 hit the west, Treasury prices went haywire as market liquidity collapsed. 

That was shocking in a sector that is normally “the largest and most liquid government securities market in the world”, according to the Federal Reserve.

Fed officials eventually unblocked the market with unprecedented interventions, gobbling up Treasuries itself. 

After peace returned, some investors — and politicians — seemed minded to sweep that horror under the rug. 

But, a year on, we need to solve the mystery of what happened for three reasons. 

First, the system came close to disaster. 

Or, as Randal Quarles, a Fed governor, has observed: “For a while in the spring [of 2020] the outcome was — as the Duke of Wellington said of Waterloo — ‘a damn close-run thing’.” 

Second, the bond market will face new stresses if (or when) US monetary policy tightens. 

Last week, the markets started to gyrate alarmingly again amid inflation concerns, and jitters intensified on Thursday.

Third, the source of the March turmoil is not widely understood. 

This is unnerving if you want to devise policy to avoid a repeat. Initially, Fed sleuthing suggested hedge funds were responsible. 

Soon after the event, Fed officials reported that “leveraged investors that bought Treasuries in the cash market and hedged the interest rate risk with futures contracts started unwinding these positions as futures prices rose, leading to a feedback loop”.

That invoked memories of the 1998 debacle around Long-Term Capital Management fund, and prompted the Financial Stability Board to call for action to “address vulnerabilities from non-bank financial intermediation” — that is, more oversight and controls. 

That appeal makes sense in a general way. 

The NBFI sector has exploded since 2008, and remains alarmingly opaque. 

Few observers even knew that hedge funds were so exposed to Treasuries before March 2020.

But subsequent Fed investigation also suggests it is a mistake to blame hedgies alone. 

One reason is that foreign institutions also dumped Treasuries in a destabilising way. 

Second, the behaviour of some of Wall Street’s big banks was odd. 

In years past, they happily acted as market makers in the Treasuries sector, since they hold vast quantities of such bonds. 

More specifically, brokers play a crucial role in the repurchase (repo) markets where investors raise finance by swapping bonds for cash, thus lubricating the wheels of finance.

But late last year a report by the New York Fed noted that during the March 2020 turmoil “relative to normal times, dealers did not make their securities as available to other market participants”, even though their stocks of Treasuries had surged. 

In plain English, this means brokers secretly went on strike. 

The turmoil was not just a demand problem — that nobody would buy Treasuries — but a supply issue, because brokers had stopped cutting deals, even for repo.

This is alarming, since it points to bigger structural issues. 

Quarles thinks the March debacle shows that the $21tn Treasuries market “may have outpaced the ability of the private-market infrastructure to support stress of any sort”. 

This is partly because US debt keeps expanding. 

But it is also because post-2008 reforms have raised the capital buffers banks need to do market-making activity, causing them to shy away. 

Either way, the situation is like an ever-swelling elephant balancing on a shrinking ball: if the ground is still, the situation might seem stable; but, if not, it is easy to tumble. 

Can this be fixed? 

Not easily. 

The Biden administration is unlikely to implement any rollback of post-2008 reforms. 

It is even more unlikely to cut the debt. 

But a recent paper from the Brookings Institution outlines some policy options, such as better monitoring of NBFI and regulatory tweaks making it easier for brokers to be market makers.

More controversially, the paper also calls for “serious consideration of a mandate for wider use of central clearing for Treasury securities” and “a new Federal Reserve standing repo facility that would serve as a backstop for the US financial system by providing funding to regulated dealers based on US Treasury and agency collateral”.

Might this fly? 

The last idea is already being implemented on a supposedly temporary basis, since the Fed only curbed the March 2020 dramas by introducing “emergency” measures to backstop repo markets. 

This is a striking extension of the central bank’s role, but it has sparked little protest, probably because few outsiders understand repo.

But relying on ad hoc emergency measures is not a good way to make policy, not least because it creates moral hazard. 

So, as the March anniversary looms, the Fed should explain to the public in easy-to-understand language what created the problem, and how to avoid a repeat.

In that respect, it would make sense to create a standing repo facility. 

There are big drawbacks to extending the Fed’s mandate (even) further: no one wants the system to become even more dependent on central banks. 

But we cannot afford to have the Treasuries market overwhelmed again, least of all as inflation concerns mount. 


Why people are worried about the bond-equity relationship

Buried in the quant argot is a fear of a return to 1970s-style inflation

Most people have little time for quants. 

They find the language of quantitative finance far from illuminating. 

Even fairly numerate people struggle to grasp what comes easily to pointy-headed number-crunchers. 

Take the idea of correlation, the co-movement of two or more variables. 

Such relationships vary with the period over which they are measured. 

The direction can shift. 

Things quickly become confusing.

Yet the quant argot is useful when considering perhaps the biggest fear stalking financial markets: a sustained rise in inflation that would be bad for both equities and bonds. 

A quant might describe this as a flip in the bond-equity correlation from negative to positive.

That is none too elegant, though. 

A better choice is a term used in geopolitics as well as econometrics: regime change.

It is helpful in this matter to start with two stylised facts. 

The first is that in recent years, bond and equity prices have tended to move in opposite directions over the business cycle. 

When recessions hit, bond prices tend to rise sharply (their yields fall) and equity prices usually crash. 

When the economy recovers, bonds tend to fall in price and equity prices go up again. 

You can think of this in terms of risk appetite. 

Government bonds are safe assets. 

People rush into them when they fear for the future. 

Equities, by contrast, are risky assets, so people shun them in troubled times.

The second stylised fact concerns a secular relationship rather than a cyclical one. Since the early 1980s bond and equity prices have moved in the same broad direction—upwards. 

If you look at low-frequency data over a long period, the bond-equity correlation is positive. 

This is best understood in terms of yields rather than prices. 

For the past four decades, there has been a secular decline in government-bond yields, reflecting a secular decline in interest rates. 

The earnings yield on equities has fallen, too, as have yields on other assets, such as corporate bonds and property. 

This should not be a surprise. 

Yields are a gauge of expected returns. 

Bonds and equities compete for investors’ capital. 

Over the long haul the prices and yields of each will respond to those of the other.

These two facts may seem at odds, but a third fact makes them consistent. 

In each business cycle, interest rates tend to rise as the economy gathers strength (so bonds and equities diverge over short periods). 

But each business-cycle peak in interest rates is lower than the previous one (so bonds and equity prices converge over the long run). 

That in turn is a response to the secular decline in inflation.

Indeed, inflation is central to the bond-equity relationship. 

It is here that things become trickier, and the notion of regime change matters. 

Bonds promise fixed cash payments in the future. 

Those cashflows are worth less when inflation unexpectedly rises. 

By contrast, equities have generally outpaced inflation over the long haul. 

But the relationship between inflation and equity prices is not stable. 

A study by Sushil Wadhwani, a former member of the Bank of England’s rate-setting committee, in 2013 found that higher inflation generally helped to boost stockmarket returns in Britain in the two centuries before 1914. 

But by the last half of the 20th century a negative relationship had emerged. 

You might best explain this finding in terms of monetary regimes. 

Under the pre-1914 gold standard, inflation was mean-reverting: if it was high one year, it would fall the next. 

But in the era of fiat money, especially in the 1970s, the checks on inflation were less binding.

In the past few decades central banks were given inflation targets, and the monetary regime switched again. 

Now, yet another regime change may be afoot. 

Fiscal stimulus is back in favour, which has an unsettling 1970s feel to it. 

Fiscal policy fell out of fashion because it was not well suited to fine-tuning aggregate demand; politicians are reluctant to cut spending or raise taxes when the economy threatens to overheat. 

And the old-style central banker—reared in academia, aloof from politics, paranoid about inflation—is now almost extinct. 

The new breed talks about climate change and inequality and is sanguine about inflation risks. 

This feeds a general sense of lost policy discipline.

Sooner or later, warn the hawks, this will end in tears. 

Many of the people who predict the return of 1970s-style inflation used to deride the old-school, bookish rate-setter, with his fancy econometrics and lack of market smarts. 

It is no small irony that they now feel so nostalgic for the pointy-headed central banker. 

The Bitcoin Lottery

The sudden rise of "special purpose acquisitions companies" and cryptocurrencies speaks less to the virtues of these vehicles than to the excesses of the current bull market. In the long term, these assets will mostly fall into the same category as speculative "growth stocks" today.

Jim O'Neill

LONDON – I was recently approached about setting up my own “special purpose acquisition company” (SPAC), which would allow me to secure financial commitments from investors on the expectation that I will eventually acquire some promising business that would prefer to avoid an initial public offering. 

In picturing myself in this new role, I mused that I could be doubly fashionable by also jumping into the burgeoning field of cryptocurrencies. There have been plenty of headlines about striking it big, quickly, so why not get in on the action?

Being a wizened participant in financial markets, I declined the invitation. 

The rising popularity of SPACs and cryptocurrencies seems to reflect not their own strengths but rather the excesses of the current moment, with its raging bull market in equities, ultra-low interest rates, and policy-driven rallies after a year of COVID-19 lockdowns.

To be sure, in some cases, pursuing the SPAC route to a healthy return probably makes a lot of sense. But the fact that so many of these entities are being created should raise concerns about looming risks in the surrounding markets.

As for the cryptocurrency phenomenon, I have tried to remain open-minded, but the economist in me struggles to make sense of it. I certainly understand the conventional complaints about the major fiat currencies. 

Throughout my career as a foreign-exchange analyst, I often found that it was much easier to dislike a given currency than it was to find one with obvious appeal.

I can still remember my thinking during the run-up to the introduction of the euro. Aggregating individual European economies under a shared currency would eliminate a key source of monetary-policy restraint – the much-feared German Bundesbank – and would introduce a new set of risks to the global currency market. 

This worry led me (briefly) to bet on gold. But by the time the euro was introduced in 1999, I had persuaded myself of its attractions and changed my view (which turned out to be a mistake for the first couple of years, but not in the long term).

Similarly, I have lost count of all the papers I have written and read on the supposed unsustainability of the US balance of payments and the impending decline of the dollar. 

True, these warnings (and similar portents about Japan’s long-running experiment in monetary-policy largesse) have yet to be borne out. 

But, given all this inductive evidence, I can see why there is so much excitement behind Bitcoin, the modern version of gold, and its many competitors. 

Particularly in developing and “emerging” economies, where one often cannot trust the central bank or invest in foreign currencies, the opportunity to stow one’s savings in a digital currency is obviously an inviting one.

By the same token, there has long been a case to be made for creating a new world currency – or upgrading the International Monetary Fund’s reserve asset, special drawing rights – to mitigate some of the excesses associated with the dollar, euro, yen, pound, or any other national currency. 

For its part, China has already introduced a central bank digital currency, in the hopes of laying the foundation for a new, more stable global monetary system.

But these innovations are fundamentally different from a cryptocurrency like Bitcoin. 

The standard economic textbook view is that for a currency to be credible, it must serve as a means of exchange, a store of value, and a unit of account. 

It is hard to see how a cryptocurrency could meet all three of these conditions all of the time. 

True, some cryptocurrencies have demonstrated an ability to perform some of these functions some of the time. 

But the price of Bitcoin, the canonical cryptocurrency, is so volatile that it is almost impossible to imagine it becoming a reliable store of value or means of exchange.

Moreover, underlying these three functions is the rather important role of monetary policy. 

Currency management is a key macroeconomic policymaking tool. 

Why should we surrender this function to some anonymous or amorphous force such as a decentralized ledger, especially one that caps the overall supply of currency, thus guaranteeing perpetual volatility?

At any rate, it will be interesting to see what happens to cryptocurrencies when central banks finally start raising interest rates after years of maintaining ultra-loose monetary policies. 

We have already seen that the price of Bitcoin tends to fall sharply during “risk-off” episodes, when markets suddenly move into safe assets. 

In this respect, it exhibits the same behavior as many “growth stocks” and other highly speculative bets.

In the interest of transparency, I did consider buying some Bitcoin a few years ago, when its price had collapsed from $18,000 to below $8,000 in the space of around two months. 

Friends of mine predicted that it would climb above $50,000 within two years – and so it has.

Ultimately, I decided against it, because I had already taken a lot of risk investing in early-stage companies that at least served some obvious purpose. 

But even if I had bet on Bitcoin, I would have understood that it was just a speculative punt, not a bet on the future of the monetary system.

Speculative bets do of course sometimes pay off, and I congratulate those who loaded up on Bitcoin early on. 

But I would offer them the same advice I would offer to a lottery winner: Don’t let your windfall go to your head.

Jim O’Neill, a former chairman of Goldman Sachs Asset Management and a former UK treasury minister, is Chair of Chatham House.