Bond vigilantes are out in force

As we head into the Easter period, global markets will be fervently hoping that the cracks that appeared in the US bond market last week don't spread. Because rising bond yields pose the most sinister threat so far both to the US share market's spectacular rally, and to the fledgling recovery in the US economy.

The mood in the US bond market darkened considerably last week, as buying dried up at US government debt auctions. On Thursday, yields on 10-year US bonds spiked to 3.93 per cent, their highest level since last June. Yields edged back on Friday, after a South Korean naval ship sank near the North Korean border, prompting some investors to seek out the safety of US bonds, but 10-year bond yields still remain precariously close to the crucial 4 per cent level.

It was clear at last week's government bond auctions that a major buyer has withdrawn from the market. The question is who?

One theory is that China temporarily suspended its purchases of US bonds, sending a clear warning to Washington of the possible consequences if the Obama administration decides to label China a 'currency manipulator'.

The other, and more likely, scenario is that the "bond vigilantes” are again on the prowl. The vigilantes first flexed their muscles in the 1980s, when they sold off bonds on concerns about rising inflation. In response, central banks pushed up short-term interest rates to stamp out inflationary pressures. This time, however, the bond vigilantes are protesting against the massive build-up of US government debt.

And they're demanding higher interest rates as the price for funding a US budget deficit that is expected to reach a massive $US1.4 trillion this year, which is roughly 10 per cent of the country's GDP.

The re-emergence of the bond vigilantes is a huge threat to the attempts by the Obama administration, and the US central bank, to reflate the US economy in the wake of the financial crisis.

The US authorities responded to the collapse in credit markets with a massive boost in government spending, combined with an unprecedented amount of money printing by the central bank.

Markets were encouraged by this show of force. They formed the view that the US government and central bank had an infinite commitment to printing money and spending in order to push up asset prices, as well as an infinite ability to do so.

Confident that they were being supported by government policy, financial markets pushed up the price of all US debt, including government debt, mortgages and corporate debt. This allowed consumers, businesses and governments to benefit from lower interest costs.

To date, US debt markets have been unfazed by the clear problems with the debt-laden countries in the euro zone,and looming budget problems in US states, such as California. If anything, they've consoled themselves with the notion that such a massive debt overhang means that the US Federal Reserve, along with the European Central Bank, will have to keep interest rates close to zero indefinitely.

But now the mood seems to be shifting. Bond markets have always known that ultimately there would be a day of reckoning, that huge government deficits and zero interest rates could not continue indefinitely.

There is now a heightened risk that the bond vigilantes are now in the ascendancy, and that they will force a repricing of risk in US bond markets. Rising bond yields will leave consumers with higher credit card and mortgage repayments, while businesses will face higher interest rates on their borrowing. And that risks choking off the already anaemic US economic recovery.