Just the term ‘bond market vigilante’ strikes fear into the heart of most finance ministers. Surveying the bond market, protesting against any fiscal policies they see as inflationary, even costing former Chancellor Kwasi Kwarteng his job back in October 2022. They raise their heads every so often, and when they do, politicians and Treasury officials should pay attention.
When a ‘bond market vigilante’ spots a government doing something they don’t like, they sell that government’s debt. This can push up government bond yields, since bond yields move in the opposite direction to price.
When government bond yields go up it makes borrowing more expensive and can even threaten the economic stability of a country. This is why governments fear ‘bond vigilantes’, because they’ve got the power to enforce change even in strong economies.
So, who are these bond vigilantes, and what are they trying to achieve? US economist Ed Yardeni coined the term back in 1983, publishing a letter entitled “Bond investors are the economy’s bond vigilantes”. His theory was that debt investors can discipline governments by selling off their bonds if they look like they’re spending irresponsibly.
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What does this mean for the UK?
Earlier in January, BlackRock warned that the UK could become a target of bond vigilantes leading up to the general election. BlackRock’s analysts are concerned that UK political parties might promise more government spending ahead of the election, and this could upset the vigilantes.
The UK has recent experience with bond market vigilantes. Back in September 2022, the promise of unfunded tax cuts in the notorious ‘mini budget’ rocked the UK bond market, causing mortgage rates to surge. Then Chancellor Kwasi Kwarteng was sacked and the short-lived Liz Truss government ended.
The UK is in the crosshairs of the bond vigilantes because of its precarious fiscal position.
The UK is in the crosshairs of the bond vigilantes because of its precarious fiscal position. It’s spending more than it’s bringing in each year, and according to the most recent data, the current account deficit was equal to 2.5% of gross domestic product (GDP) in Q3 2023.
In simple terms, a current account deficit is like living in your overdraft and never getting your bank balance back above £0. This can be a risky position and doesn’t leave much room for unexpected events. An unexpected event like the COVID-19 pandemic in 2020.
During that time, the government was borrowing large amounts to pay furlough schemes and fund the NHS. The UK’s deficit grew, and in the first quarter of 2022, the deficit was -7.5% of GDP. The deficit might have shrunk recently, but governments who run continuous current account deficits still need to be careful when making spending decisions.
What about bond vigilantes in the US?
The US also has a long-term current account deficit, which has been rising under the Biden administration. In 2023, the US government had to borrow $1.7tn to fund its $6.13tn of spending commitments.
This extra government debt last year also caught the attention of bond market vigilantes. They sold US Treasuries in October causing the yield on 30-year bonds to rise above 5%, while the 10-year yield rose to its highest level since 2007.
For many years the ‘bond market vigilantes’ were content with the low level of inflation during the 2010’s. Since inflation came back with a bang after the pandemic, the possibility of bond market vigilantes striking government debt markets became a real and present danger.
More recently, in August 2023, the US current account deficit widened and the US Treasury started to sell more debt. One such 'vigilante' was hedge fund manager Bill Ackman, the billionaire founder of Pershing Square Capital Management.
Back in August 2023, Ackman wrote on X (formerly twitter) that he would start to sell 30-year US Treasuries. He said he would sell bonds because he wanted a long-term hedge for his equity positions in a world with 'persistent 3% inflation'.
Ackman eventually closed his short position in US Treasuries back in October 2023, saying that geopolitical risks had risen, which should drive investor flows back into US debt. He was right, since reaching a peak in October 2023, the yield on 10-year US Treasuries has fallen nearly 0.90%. As bond yields fall, bond prices have tended to rise.
What’s next on the horizon?
As we start 2024, the bond market looks vigilante free, for now. Since the start of January, yields on both US and UK 10-year government bonds have been stable, as the market ramps up predictions that interest rates will start to fall now that inflation has moderated around the world.
However, while the UK might have seen its bond yields fall, making it cheaper for governments to borrow, politicians should think twice before promising to spend more money than the country can afford. If they do, they might live to regret it as the bond market vigilantes watch their every move.