PROJECT SYNDICATE: Bond Vigilantes! Or Is It "Bond Vigilantes?'?
Normal countries, countries with “exorbitant privilege”, and the threat of the loss of same. For even for those those with “exorbitant privilege” cannot be confident the privilege will stick. For...
Normal countries, countries with “exorbitant privilege”, and the threat of the loss of same. For even for those those with “exorbitant privilege” cannot be confident the privilege will stick. For them the rules are different—until they aren’t. Looking back at the fall of Liz Truss and the rise of Bill Clinton’s “fabulous decade”. The looming question for today: When do bond markets start cracking the whip? The leash is short for most economies—but even the strongest currencies can lose their safe-haven status if policymakers forget the risks…
Extended Version
J. Bradford DeLong: What Role for the Bond Vigilantes?: "Bond vigilantes"—investors who sell off a country's bonds if they fear irresponsible fiscal policy—have long played a crucial role. Their appearance disciplines governments' borrowing and spending decisions. And fear of their sudden appearance on the horizon anticipatorily disciplines, governments' borrowing and spending decisions.
In most countries, their influence is both immediate and can be severe.
If investors lose confidence, interest rates spike. If the country has any significant debt that needs to be rolled over soon, borrowing costs threaten to become unsustainable. Economic turmoil often follows, and political turmoil always follows as the debt-servicing shock hits the government budget.
The leash, in other words, is short for countries with any considerable amount of debt that they soon need to rollover.
However, there are a few exceptional countries that possess what Valér Giscard d’Estaing labeled and what economist Barry Eichengreen has popularized as exorbitant privilege. That is the ability to issue debt and currency that the world treats as one of its ultimate safe assets. Whenever there is a “flight to safety” in the world economy, demand for such assets rise. And, as long as the country retains its exorbitant privilege, there is no place safer in terms of asset classes to flee to.
For these nations—most notably the United States, and to a lesser extent historically the United Kingdom and, today, the eurozone and Japan—the typical bond market constraints are much looser.
Investors are willing to hold their debt even at very low interest rates because they see it as a secure store of value, rather than a risk-laden financial asset. In a sense, these countries' government debt functions more like deposits in a highly trusted bank—akin to the role played by early-modern institutions like the Medici Bank—where people effectively pay for the privilege of storing their money safely, rather than expecting high returns in compensation for risk.
Yet even for countries with exorbitant privilege, the bond market's discipline is not entirely absent. The key risk is the potential loss of that privileged status, which, if it happens, can be sudden, destabilizing, and extremely difficult to reverse.
The United Kingdom under Liz Truss and Kwasi Kwarteng in 2022 provided a stark reminder. Their ill-conceived fiscal plans—massive unfunded tax cuts in an already fragile economic environment—shattered market confidence almost overnight. Gilt yields soared. The pound plummeted. Their government collapsed in record time. Most of the fallout was the result of the peculiar politics of the Palace of Westminster, rather than any material harm to the U.K. economy. But there was fallout.
By contrast, U.S. policymakers in the 1990s in Bill Clinton’s administration were acutely aware of the need to maintain financial market confidence and to guard and protect the U.S.’s exorbitant privilege. Their fiscal strategy—centered around deficit reduction, careful monetary-fiscal coordination, and a commitment to preserving the dollar’s status as the world’s reserve currency—helped sustain America’s exorbitant privilege, reinforced global trust in U.S. debt markets, and produced what Alan Blinder and Janet Yellen named the “fabulous decade” of extraordinarily good macroeocnomic performance.
Thus, even in the most privileged nations, policymakers need to keep this reality in their peripheral vision. Markets may seem forgiving, but the moment they turn, the consequences can be swift and brutal. And they can turn whenever there are alternatives—other assets than their debt—that can fulfill safe-harbor roles equally well.
Others commented as well. What do I think of their comments?
Ed Yardeni thinks that the “bond vigilantes” could blow a hole in Trump’s fiscal agenda—that the interest rate rises from tax-cut extension coupled with no meaningful spending cuts could cause enough Republican defections to sink whatever Reconciliation bills Johnson and Thune try to move this year.
I don’t believe it—the bond market may freak out, but the tax-cut extensions will roll forward with even the shabbiest of promises of future government economy measures.
Brigitte Granville thinks that central banks can keep bond-market freakouts from being more than an occasional thing even in vulnerable countries, but that the fact that politicians keep score by the stock market, both for public-communications and for supporter-wealth reasons. This has long been the case: 150 years ago Friedrich Engels wrote of how:
The German Empire is just as completely under the yoke of the Stock Exchange as was the French Empire in its day. It is the stockbrokers who prepare the projects which the Government has to carry out—for the profit of their pockets. Yet in Germany they have an advantage which the Bonapartist Empire lacked: if the Imperial Government encounters resistance among its princelings it turns into the Prussian Government, which will certainly not find any in its own chambers, true branches of the Stock Exchange that they are…
I am not sure—but this is certainly what the Scott Bessent affinity is telling us.
Paola Subacchi believes that the U.S. is more or less immune—that exorbitant privilege will see us through, even though worldwide government debts are alarmingly high—111% of annual GDP across richer and 72% across poorer countries.
And she is highly likely to be correct.
Plus we have Desmond Lachman assessing the situation thus: anyone doubting the reappearance of the bond vigilantes has simply not processed the 1.0%-point rise in Treasury yields coupled with the 1.0%-point fall in the monetary policy rate. That such a huge swing has come about purely based on anticipations that Trump and his coalition will further bust the budget is conclusive.
And I find it very hard to argue with him.
More generally, it is important to keep yourself anchored to the fact that bond vigilantes are not mystical entities that lurk in the shadows, ready to pounce when governments misbehave. Investors are not trying to “discipline> The discipline emerges, but there is no singular mind behind it. And to think as though there is leads to confusion.
Key also is whether central banks are and can remain independent, or will succumb to fiscal dominance. When a country has an independent central bank that has credibly committed to controlling inflation and ensuring liquidity, the bond vigilantes tend to stay very quiet—the fiscal authority has enormous borrowing room, as long as such borrowing does not shake faith in the inflation target. The key to the Liz Truss disaster, after all, was the sudden fear by market participants that the Bank of England might not (or could not) backstop stability. That’s what triggered the bond market panic.
The last key question is not whether bond vigilantes are suddenly “returning,” but rather under what conditions financial markets will begin to see their confidence erode in an exorbitant privilege-possessing country’s long-term ability to provide stable, liquid, and low-risk assets.
Other people’s comments in the same feature:
Higher interest rates and growing government debts and deficits have led many financial commentators to wonder if policymakers in major economies should be more worried about the bond markets - a famously exacting source of discipline when all else fails. Are they on to something?
PS Quarterly regularly features predictions by experts on topics of global concern, and as we move further into 2025, the macroeconomic outlook has moved to the top of the list. Following the long era of low interest rates during the 2010s, the return of inflation and higher sovereign bond yields since the pandemic has led many in the financial press to proclaim that the “bond vigilantes are back.”
Coined by the investment strategist Edward Yardeni in the 1980s, the term captures sovereign-debt investors’ role of constraining the scope of economic policymaking. While traditionally associated with chronically troubled economies like Argentina, the bond-vigilante effect is increasingly factoring into analyses of major advanced economies such as the United States, too. Nor is this development confined to speculation by pundits. “If you’re seeking clues about the potential for bond vigilantism, you might start by asking the largest fixed income investors – who theoretically hold the most market sway – what they’re doing,” write two strategists at PIMCO, which is “already making incremental adjustments in response to rising US deficits.”
To assess whether this sentiment represents a new normal, we asked contributors if they agree or disagree with the following proposition:
“Bond vigilantes” will become a persistent issue for major economies.
Edward Yardeni: Almost every time that bond yields jump higher just about anywhere in the world, I get at least one reporter calling me asking if the bond vigilantes are behind the move. I coined the term back in the July 27, 1983, issue of my weekly commentary, under the headline “Bond Investors Are the Economy’s Bond Vigilantes.” I concluded: “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.”
Of course, bond investors are not thinking about regulating the economy. They are simply acting in their perceived financial best interest – that is, out of increasing or decreasing concern that inflation might erode the effective purchasing power of their returns. A related concern is that deficit-financed fiscal policy is excessively stimulative, which increases the risk of inflation and adds further to the debt. Excessively stimulative monetary policy is especially alarming if it is enabling the profligacy of fiscal policy.
The bond vigilantes did play an important role in regulating the business cycle during the 1980s. They were less important during the 1990s, because US President Bill Clinton was warned by his economic advisers to maintain fiscal discipline or face their wrath. Now, it seems that US Treasury Secretary Scott Bessent is trying to convince his boss, President Donald Trump, that the bond market is more important than the US Federal Reserve.
The bond vigilantes are biding their time, waiting to see how the Trump administration will slow the increase in spending as a result of the Department of Government Efficiency’s efforts. If they don’t deliver enough spending cuts, there could be a gunfight at DOGE city, with the bond vigilantes shooting holes in Trump’s fiscal agenda, including his promised extension of the 2017 tax cuts.
Brigitte Granville:I disagree with the proposition. Even smaller countries’ greater vulnerability to bond vigilantes will be occasional, rather than persistent. Nonetheless, such vigilantism – understood as financial markets constraining governments’ choices – could prove effective not through bonds but rather equity markets.
Consider the basic arithmetical expression of public-debt sustainability: The rate of economic growth (“g”) must exceed government bond yields (“r”), or the government must achieve an offsetting primary (excluding interest payments) budget surplus. Major economies that issue public debt in their own currencies can cap “r” by creating money. Similarly, ever since 2012, when then-European Central Bank President Mario Draghi promised to do “whatever it takes” to save the euro, eurozone countries that lack monetary sovereignty have relied on the ECB for the same purpose. In these cases, vigilantes have learned not to bet against central banks.
What about “g”? As someone who disagrees with the “secular stagnation” school, I would point out that today’s higher interest rates reflect stronger demand for capital to fund productivity-enhancing investment. The resulting positive growth trend will counter vigilante concerns about inflationary budget deficits, as well as eliminating the need for “austerity” – which has been thoroughly discredited, both economically and politically.
Of course, periodic supply shocks, especially those affecting energy, imply some residual vigilante risk. These events are bad for both growth and inflation, with the latter aggravated in the case of smaller open economies like the United Kingdom by the resulting currency weakness. Sheltered from this risk by “King Dollar,” the US faces a different problem: its pro-growth investment could be inhibited by today’s deep policy uncertainties. Still, if bad equity-market reactions can discipline the Trump administration, the US Federal Reserve can continue to support the bond (Treasury) market.
Paola Subacchi: Government debt is alarmingly high. It has reached 111% of GDP across advanced economies, and 72% in developing countries. Many countries are in serious debt distress, and some have already defaulted. With interest rates relatively high, lackluster economic growth and mounting fiscal pressures will make it increasingly difficult to manage existing debts, and this will raise concerns among debt investors.
Does this signal the return of bond vigilantes? The recent spike in UK gilt yields suggests some discomfort among investors about the new Labour government’s fiscal policy. In mid-January, the 30-year gilt yield hit 5.5%, reflecting the fact that UK inflation remains notably higher than in other G7 countries. However, much of this surge reflected broader portfolio adjustments, rather than direct concerns about fiscal policy.
Even in the case of former UK Prime Minister Liz Truss’s infamous mini-budget crisis in 2022, there were mixed signals. There were certainly market concerns about the government’s plan to increase borrowing without clear funding strategies. But the crisis was exacerbated by pension funds using gilts to hedge their long-term liabilities. The sudden drop in gilt prices triggered substantial collateral calls, forcing these funds to sell more gilts and driving prices further down in a self-reinforcing cycle.
As for the US, yields remain stubbornly high. Yet this is not necessarily an unambiguous sign of investors’ dwindling confidence in US fiscal policy. Instead, it reflects the complex dynamics of US capital markets, including the large equity premium. Ultimately, US Treasuries are the world’s preeminent safe asset. No other markets for safe assets denominated in major reserve currencies offer the size and depth required to meet the massive global demand – particularly the demand for official foreign-exchange reserves. So far, this demand has been sufficiently resilient to weather the actions of disillusioned bond investors.
Desmond Lachman: Anyone doubting the strong likelihood of the bond vigilantes’ return has not been paying attention to the recent, strange developments in US ten-year Treasury bond yields (as of this writing in early February). Nor have they been paying attention to President Donald Trump’s budget-busting tax-cut proposals.
Since last September, when it became apparent to markets that Trump was likely to win the election, the ten-year Treasury yield has risen by around 100 basis points even as the Federal Reserve has cut its policy rate by the same amount (from 5.25-5.5% to 4.25-4.5%). It did so on the expectation that the US budget deficit would rise meaningfully from its already worryingly high level of around 6.5% of GDP.
According to the Committee for a Responsible Federal Budget, Trump’s tax-cut proposals would add $7.75 trillion to the US national debt over the next decade, pushing the debt-to-GDP ratio above 140% by 2034. If implemented, such massive tax cuts are bound to raise serious questions about the sustainability of US public finances, and that in turn would constitute an open invitation for the bond vigilantes to return in full force.
& Earlier:
Brad DeLong (2023): After 30 Years, the Bond Market Vigilantes Are Back! <https://braddelong.substack.com/p/after-30-years-the-bond-market-vigilantes>
You once gifted me a short but very interesting book titled, "The End of Influence: What Happens when Other Countries have the Money?" written by Stephen Cohen and some other guy, I can't recall at the moment. Anyway, this post about "countries with 'exorbitant privilege'" and that book's discussion of the end of such privilege ... Where is the US today vis-a-vis that book's prediction in 2010?
"an independent central bank that has credibly committed to controlling inflation and ensuring liquidity,
Read "FAIT" that guarantees only sufficient inflation to allow relative prices to adjust to natural and policy shocks, but not more. That could still be quite a bit with this Administration.