Monday, June 18, 2012

The Return of the Bond Vigilantes

A generation ago, when government budget deficits swelled to troubling levels, elected officials failed to take responsible action to cut spending or increase revenues.  But another group of actors appeared, dubbed the "Bond Vigilantes," to force action.  Participants in the U.S. government bond market sold bonds and drove interest rates higher because of a lack of confidence in elected officials.  This continued to the point where even the elected officials knew they had to act because the borrowing costs for the government were rising sharply.

In the last decade, observers have lamented the disappearance of the Vigilantes, as budget deficits exploded in both the Bush and Obama Administrations, yet interest rates kept falling (not rising).  With interest rates on U.S. Treasury 10-year notes at only 1.6%, the vigilantes have not returned to the U.S.  

But they have returned to Europe, as despite a 100 billion Euro bailout for Spanish banks, yields on Spanish government notes today rose to 7.15%, a dangerous level that preceded collapses in Ireland and Greece.  When confidence goes, whether in a bank or a government, it is hard to keep the situation from spinning out of control.

When the Vigilantes act in unison, their momentum is difficult to reverse.  It will probably require coordinated central bank intervention, along with significant European policy coordination, can stanch the unraveling and lead to higher asset prices.

Steve Lehman

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