Are the Bond Vigilantes Really Dead?

(Bloomberg Markets) -- “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” That was political strategist James Carville back in 1993.

Younger readers might find the characterization of the bond market from a quarter century ago a bit bemusing. For them, the “bond market vigilantes” are little more than figures in a scary story that grizzled fixed-income investors use to keep young folks on the straight and narrow. After all, the Bloomberg terminal is full of bond quotes offering almost absurdly low yields despite elevated levels of public debt.

As the public policy debate shifts to the possibility of increased spending in many parts of the world, it's worth asking if the bond vigilantes are well and truly dead—and if so, whether they ever actually existed in the first place. After all, if governments can borrow as much as they like without repercussion, then a host of seemingly outlandish policy proposals may suddenly become more realistic.

Anyone who has a passing familiarity with euro zone bond markets could tell you that sovereign debt levels matter. Indeed, it took European Central Bank President Mario Draghi's “whatever it takes” pledge in 2012 to break a doom loop of European sovereigns and banks. More recently, the Italian government's defiance of European Union budget prescriptions pushed Italian bond yields higher. What's that if not the bond vigilantes in action? Indeed, looking across the major economies of the euro zone we find a pretty strong relationship between public debt and the cost of borrowing.

Ah, but, the “debt doesn't matter” crowd might suggest, the euro zone is a special case. None of the individual countries enjoys seigniorage: They can't simply print money to pay off their debts. For countries that do control the printing press, debt ultimately has little impact on yields. Just look at Japan: Gross government debt is more than twice gross domestic product—the Bank of Japan has monetized almost half of that debt—and 10-year yields are around zero.

If the euro zone is a special case, then so, too, is Japan, insofar as it's run a persistent current-account surplus over the past several decades. There is a high stock of domestic savings with a strong home bias, which has ensured a steady demand for Japanese government bonds despite the ostensibly shaky financial fundamentals. Regardless, it seems a bit of a stretch to suggest that Japan's high public debt level and low bond yields have created an optimal set of economic outcomes. The bloated size of the public-sector balance sheet has arguably squeezed private-sector debt out of the market.

But what about the U.S., the biggest bond market? Although a succession of Federal Reserve chairs has warned about the unsustainability of America's debt trajectory, the bond market seems notably blasé. Of course, that probably has something to do with the low policy rates and inflation, as well as the anchoring aspects of forward guidance.

Still, the past decade has seen a notable increase in federal debt even as benchmark yields are below levels that prevailed for much of the Great Recession. So, do debt levels (or more to the point, deficit levels) have any power to explain yields?

To test this, I created a simple model using a few basic factors to see how their importance evolves over time. I regressed the 10-year Treasury yield against the federal government budget balance, core inflation, and the fed funds target rate since 1971 (when data on the latter became available) and calculated model coefficients for each of the decades. If deficits (the factor that explains much of the change in the stock of public debt) have ever mattered for yields, then it should show up in this study.

Sure enough, it does. During the 1970s and '80s (most of the period that informed Carville's bond market take), each increase in the budget deficit of 1 percent of GDP equated to a roughly 90-basis-point rise in 10-year yields. (See table. Note that a negative budget balance times a negative coefficient results in a positive impact on yields.) The impact fell to 55 basis points per unit of GDP in the 1990s, but the result was still highly statistically significant. It's worth noting that core inflation had almost no bearing on yields during that decade.

In the 2000s, however, the budget balance was utterly irrelevant as a bond market determinant. If the worldview of older economists was shaped by the inflationary 1970s, then it's pretty easy to see what informed the belief of younger colleagues that debt doesn't matter.

Yet there's no guarantee that debt will never matter again. Last year funding markets saw some disruption from increased Treasury bill issuance, which crowded out some dollar borrowing from foreign banks. More generally, the coefficient between bond yields and budget deficits has risen, and though it's still modest at 15 basis points per 1 percent of GDP on the deficit, it's notable that the coefficient is once again statistically significant—despite the trillions of dollars of quantitative-easing bond buying from the Fed.

Markets have a funny way of proving investors and policymakers wrong just when they think something doesn't matter. It's true that the dollar occupies a special place in the global financial system, but such primacy isn't always a permanent feature of the landscape: Just look at the fortunes of sterling in the first half of the 20th century.

It's probably not a coincidence that the sensitivity of Treasuries to deficit and debt levels has declined as the role of foreign-exchange-reserve managers has increased in recent decades. Yet it seems reasonable to posit that the growth in FX reserves should moderate in the future as mercantilist policies become less acceptable around the world. The implication is that just because debt hasn't tripped up markets lately doesn't mean it won't in the future.

Crise is a macro strategist who writes the Macro Man column for Bloomberg and blogs for Markets Live.

To contact the editor responsible for this story: Jon Asmundsson at jasmundsson@bloomberg.net

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