Beware the bond vigilantes

Bond market vigilantes are at it again, forcing governments around the world into action just like in the 1980s – except this time it's not about inflation.

In August 1982 the Australian 10-year government bond yield peaked at 16.5 per cent, having roughly tripled since 1970. The government was facing a crippling budget deficit just to pay interest on existing debt.

With the benefit of hindsight, that was the end of a 30-year global bear market for bonds (as the price falls, the yield rises).

In 1970, a 6 per cent return for a risk-free government investment seemed little short of fabulous, but thanks to the Great Inflation of the 1970s, it turned out to be dreadful: 10 years later the yield was 10 per cent higher and bonds were worth a fraction of the price. Fixed interest investors were wiped out, leading to a generation of over-investment in equities.

‘Bond vigilantes’ – a term coined in the 1980s – forced governments around the world to control inflation. Never again would they allow politicians to slowly rob them through the expansion of money and rising prices.

Fast forward 30 years and the bond vigilantes are at it again, except this time they are demanding monetary expansion. Governments that don’t print money are ferociously punished, and those that do are richly rewarded with yields below 2 per cent, or even 1 per cent.

For example, in early September the Swiss National Bank said it was "prepared to buy foreign currency in unlimited quantities” to enforce an exchange rate of 1.2 francs to the euro. Having thus promised to print unlimited amounts of money, Switzerland was given a cut in its 10-year bond rate from 1.3 per cent to 0.9 per cent.

The UK has had four rounds of quantitative easing (QE), or money printing, and its 10-year bonds, or gilts as they are called there, have fallen from 3.8 per cent to 2.3 per cent in six months. The US Fed has had the TARP, QE 1, QE 2 and the Twist, printing money like there’s no tomorrow, and yet the 10-year Treasury bond is stuck at a 2 per cent yield.

The eurozone, on the other hand, is being tormented by the bond vigilantes, who are using the lash of bond yields to demand that the European Central Bank falls into line and prints money. The ECB has bought €209 billion worth of bonds since May 2010; in the past three months its balance sheet has expanded at an annual rate of 77 per cent, but it’s not enough.

With €1.2 trillion of European government debt to be refinanced in 2012, the bond market is putting intolerable pressure on the ECB and Germany to abandon their ‘conservative’ ways and print more money. If the December 9 summit doesn’t produce a capitulation to the bond vigilantes, their fury could be catastrophic for global markets.

How on earth did we get to this point, where the bond market vigilantes have gone from demanding monetary discipline to demanding the exact opposite?

The answer is both simple, and frightening. The world’s marginal fixed interest investors have gone from being long-term risk managers to short-term yield arbitrage slurpers.

What they want is cheap money. They don’t give a monkey's about inflation or deflation – just give us a fix of near-zero interest rates so we can make easy profits on the carry.

They don’t care whether the euro stays together. They have very little interest in fiscal policy – in fact, deficits are good because it means there are more bonds to play with. Their only concern, and the reason they want better fiscal policies, is the prospect of a hard default, but that’s not really much of a concern: they know the firestorm they would unleash on those responsible would be so horrendous that it’s very unlikely to happen.

What they want is to be bailed out with money created from thin air by the ECB. Inflation? Who cares?

The only western government immune from the bond market’s predation is Australia, because it has little sovereign debt and a plan to return to surplus, such as it is. But we are directly vulnerable to what happens because our banks rely on wholesale debt from the same sources as Europe’s miserable governments. Close one bond market and you close them all.

Yesterday’s failure to pass on the RBA rate cut is a consequence of that reliance.

There was a time when European and American governments might have satisfied bond markets and lowered the interest rate on their long-term debt simply through tight, responsible fiscal policy.

Not any more. What’s required now is a willingness to create euros and dollars, and to keep the price of money down in the short-term so the hedge funds that control marginal pricing can continue to get rich – at least until the inflation catches up with them. But they’ll be long gone by then, or so they believe.

As the newsletter Grant’s Interest Rate Observer wryly declared last week: "we hew to the doctrine that the place in which you find real money is a mine.”

Follow @AlanKohler on Twitter


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