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IN TOM Wolfe's classic novel, Bonfire of the Vanities, the main character is a bond trader who sees himself as "Master of the Universe". Though today it's more the hedge fund managers who have that tag, bond traders still have a lot of power.
That was clearly illustrated in the bouts of market instability during the eurozone sovereign debt crisis, when bond yields of highly indebted countries soared. This kind of market action is brought about by the "bond market vigilantes". The phrase refers to the selling by bond traders that forces governments to implement the right policies – cutting deficits and fighting inflation.
Bonds are sensitive to inflation and government debt. Inflation, because the higher the inflation rate the higher the nominal yield needs to be to provide an adequate real return. Government debt, because the higher the supply of bonds the higher the yield needs to be for the bonds to be taken up by the market.
(Note: high bond yields are a bad thing, because the higher the yield, the lower the face value of the bond. In the US, home loan rates are tied to long bond yields, which obviously shows that the higher the yield, the higher the home loan rate.)
There has been a run-up in US bond yields this year, away from the excessively low rates that prevailed as recently as October 2010, when 10-year notes yielded a low of 2.33%. The current 10-year yield is around 3.62%.
That's a significant rise. Do the bond market vigilantes have anything to do with it?
The short answer is no. So far, the run-up in US bond yields has been explained by a return to growth in the US and expectations of quite good growth this year. Growth means the US Federal Reserve will reverse its excessively loose monetary policy and eventually raise interest rates from the current level of 0% to 0.25%.
It won't even take much of an inflation threat for that to happen; all that is needed is for the output gap – the gap between actual and potential output – to close.
As a first step, the Fed will reverse the bond purchases it has made as part of its quantitative easing 2 plan. In terms of the plan, the Fed is purchasing bonds to the tune of $600bn, an initiative announced in November last year.
It doesn't take a rocket scientist to work out that if the Fed is purchasing bonds, it places a lid on the level that yields can reach.
So, even if the bond market vigilantes wanted to push yields very much higher, they wouldn't succeed. But the Fed's policy has a sell-by date, lest the US wants to risk inflation as a result of pumping billions into the economy.
So far, the run-up in US yields has been ascribed to the return of growth to the US. Economists are optimistic. US retail sales increased 0.5% last month after a 0.6% gain in December, according to the median forecast of 77 economists in a Bloomberg News survey.
A separate survey showed US housing starts are expected to rise at an annual rate of 540 000 in January from 529 000 in December.
Sign of a normalising economy
But perhaps the economists are being too optimistic. US gross domestic product (GDP) in the fourth quarter rose by less than market expectations: 3.2% versus forecasts of 3.5%. Still, the figure was encouraging. The International Monetary Fund (IMF) recently revised its 2011 growth forecast for the US upwards by 0.7 percentage points to a growth rate of 3% for the year.
The forecast change was mostly due to a fiscal package passed in the US in late 2010. The package extended the so-called Bush tax cuts for the rich, but also included other tax cuts and improved unemployment benefits.
The IMF warned that, though growth would rise in the medium term, the US would have to start tackling its deficit if it didn't want to harm medium-term growth prospects. I think if the US fails to tackle the deficit, the bond market vigilantes will descend with a vengeance.
The US deficit for the current fiscal year is forecast to hit a record $1.6 trillion – a whopping 10.9% of GDP. President Barack Obama has announced plans for a cut to $1.1 trillion in 2012, 7% of GDP.
By 2015 the budget deficit would decline to $607bn, or 3.2% of GDP. But it remains to be seen whether the political will exists to execute these cuts.
The run-up in US bond yields – though quite large – has come off a very low base and is a sign of an economy normalising. Bloomberg News reports Martin Mitchell, head government bond trader at brokerage firm Stifel Nicolaus & Co, as saying: "We are settling into a higher yield range.
"We have seen improving economic fundamentals of late, and improving data should continue to help solidify higher yields throughout the first quarter."
True as this may be for now, the bond market vigilantes are waiting in the wings, watching the US budget deficit, which absolutely must be cut.
For SA, the run-up in US bond yields puts upward pressure on our own bond yields, because the US rate is regarded as the global benchmark. If the US deficit is not cut over the next few years, destabilisation and global financial market crisis would be the result.
- Fin24
That was clearly illustrated in the bouts of market instability during the eurozone sovereign debt crisis, when bond yields of highly indebted countries soared. This kind of market action is brought about by the "bond market vigilantes". The phrase refers to the selling by bond traders that forces governments to implement the right policies – cutting deficits and fighting inflation.
Bonds are sensitive to inflation and government debt. Inflation, because the higher the inflation rate the higher the nominal yield needs to be to provide an adequate real return. Government debt, because the higher the supply of bonds the higher the yield needs to be for the bonds to be taken up by the market.
(Note: high bond yields are a bad thing, because the higher the yield, the lower the face value of the bond. In the US, home loan rates are tied to long bond yields, which obviously shows that the higher the yield, the higher the home loan rate.)
There has been a run-up in US bond yields this year, away from the excessively low rates that prevailed as recently as October 2010, when 10-year notes yielded a low of 2.33%. The current 10-year yield is around 3.62%.
That's a significant rise. Do the bond market vigilantes have anything to do with it?
The short answer is no. So far, the run-up in US bond yields has been explained by a return to growth in the US and expectations of quite good growth this year. Growth means the US Federal Reserve will reverse its excessively loose monetary policy and eventually raise interest rates from the current level of 0% to 0.25%.
It won't even take much of an inflation threat for that to happen; all that is needed is for the output gap – the gap between actual and potential output – to close.
As a first step, the Fed will reverse the bond purchases it has made as part of its quantitative easing 2 plan. In terms of the plan, the Fed is purchasing bonds to the tune of $600bn, an initiative announced in November last year.
It doesn't take a rocket scientist to work out that if the Fed is purchasing bonds, it places a lid on the level that yields can reach.
So, even if the bond market vigilantes wanted to push yields very much higher, they wouldn't succeed. But the Fed's policy has a sell-by date, lest the US wants to risk inflation as a result of pumping billions into the economy.
So far, the run-up in US yields has been ascribed to the return of growth to the US. Economists are optimistic. US retail sales increased 0.5% last month after a 0.6% gain in December, according to the median forecast of 77 economists in a Bloomberg News survey.
A separate survey showed US housing starts are expected to rise at an annual rate of 540 000 in January from 529 000 in December.
Sign of a normalising economy
But perhaps the economists are being too optimistic. US gross domestic product (GDP) in the fourth quarter rose by less than market expectations: 3.2% versus forecasts of 3.5%. Still, the figure was encouraging. The International Monetary Fund (IMF) recently revised its 2011 growth forecast for the US upwards by 0.7 percentage points to a growth rate of 3% for the year.
The forecast change was mostly due to a fiscal package passed in the US in late 2010. The package extended the so-called Bush tax cuts for the rich, but also included other tax cuts and improved unemployment benefits.
The IMF warned that, though growth would rise in the medium term, the US would have to start tackling its deficit if it didn't want to harm medium-term growth prospects. I think if the US fails to tackle the deficit, the bond market vigilantes will descend with a vengeance.
The US deficit for the current fiscal year is forecast to hit a record $1.6 trillion – a whopping 10.9% of GDP. President Barack Obama has announced plans for a cut to $1.1 trillion in 2012, 7% of GDP.
By 2015 the budget deficit would decline to $607bn, or 3.2% of GDP. But it remains to be seen whether the political will exists to execute these cuts.
The run-up in US bond yields – though quite large – has come off a very low base and is a sign of an economy normalising. Bloomberg News reports Martin Mitchell, head government bond trader at brokerage firm Stifel Nicolaus & Co, as saying: "We are settling into a higher yield range.
"We have seen improving economic fundamentals of late, and improving data should continue to help solidify higher yields throughout the first quarter."
True as this may be for now, the bond market vigilantes are waiting in the wings, watching the US budget deficit, which absolutely must be cut.
For SA, the run-up in US bond yields puts upward pressure on our own bond yields, because the US rate is regarded as the global benchmark. If the US deficit is not cut over the next few years, destabilisation and global financial market crisis would be the result.
- Fin24
