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.
-James Carville, Democratic Political Advisor, February 1993
There used to be a time when governments feared the bond market, and in particular, the bond vigilantes. The term ‘bond vigilantes’ was coined in the 1980s and refers to investors who sell their holdings in an effort to enforce discipline on fiscally irresponsible politicians.
Today, the bond market is a shadow of its former self. Unorthodox monetary policy has put bond vigilantes under lock and key as investor attention has moved away from fiscal discipline. However, with the U.S having just passed a tax bill that promises to add $1.9 trillion onto U.S debt levels in the next decade and politicians toying with the idea of further tax cuts and spending bills, will bond vigilantes stage a comeback?
As highlighted in the below chart, the U.S budget deficit is expected to expand from 3.5% of GDP in 2017 to 5.1% by 2028. This will likely see U.S debt rise from 77% of GDP in 2017 to 96% by 2028, its highest level since World War II. These forecasts however, assume no further changes to tax and spending programs, and could be knocked off course depending on the severity of the next economic slow-down. Theoretically, with an expansionary fiscal back-drop, investors should demand a higher yield to compensate them for the additional risk they are taking on. However, U.S. bond yields and budget deficits have not had a statistically significant relationship since 1990 – a dynamic that is unlikely to suddenly shift in the near future.
In summary, bond vigilantes are unlikely to stage a sudden resurgence, but that doesn’t mean investors should overlook expanding debt levels and growing budget deficits. Fiscal discipline is important, and a lack of it can hurt economic performance; for example, a 1% rise in the cost of borrowing on US debt would cost the U.S taxpayer an additional $150 billion per year in interest costs. Thus, while the bond vigilantes may be dormant right now, with debt levels rising, politicians would be wise not to push their luck and potentially wake them from their slumber.
Federal budget surplus/deficit
% of GDP, 1990-2028, 2018 BBO Baseline
Source: BEA, Treasury Department, CB, J.P. Morgan ASSET management, 2018 Federal Budget is based on the congressional budget office (CBO) April 2018 Baseline Budget Forecast. CBO Baseline is based on the congressional Budget Office (CBO) August 2018 Update TO ECONOMIC Outlook. Note years shown are fiscal years (Oct. 1 through Sep. 30). Data are as of September 30, 2018.