UK turmoil spawns return of bond vigilantes

The turmoil in the UK bond market threatens not only the stability of the country’s financial system, but also the economic and social well-being of most of its citizens. This is a situation that is going from bad to worse, and other countries must monitor it carefully. At the root of the recent disruption is the re-emergence of bond vigilantes – a debt-disciplining financial force that, long suppressed, is beginning to reassert itself. The British story is now well known. ‘Government in a hurry’ is pulling out all the stops and promising not only energy price protection for households and businesses and growth-enhancing structural reforms, but also deep unfunded tax cuts . It does so against the backdrop of a global increase in borrowing costs. It is not surprising that the markets strongly oppose implicit increases in the amount of debt, interest payments and the debt-to-GDP ratio. The resulting sharp rise in yields reveals the great fragility of a pension system that has resorted to financial engineering to improve yields. Given the threat of financial and economic contagion, the Bank of England has no choice but to intervene in a manner contrary to its ongoing mission to reduce high inflation. The government is making a partial U-turn, but it’s not significant enough to sustainably improve the momentum at play. The resulting market calm quickly gives way to more turbulence, forcing an expansion of BOE intervention . It is tempting to think that the underlying market dynamics are confined to the UK. They are not. They are likely to spread to varying degrees to a growing number of countries in the world, including those traditionally considered the strongest, such as Germany. What we are seeing is the return of the so-called bond vigilantes. Their de facto role is to impose debt discipline. Their ammunition withdraws from buying bonds issued by those they deem to be misbehaving. Their strength comes from the threat of financial disruption contaminating economic and social well-being. Their weakness comes from their tendency to overshoot. These vigilantes had been deeply suppressed by more than a decade of unconventional monetary policies – that is, zero interest rate floors and massive and recurrent central bank bond purchases. Unable to withstand such force, they fall asleep. Their inattention was rational and they were largely forgotten by bond issuers. Persistently high inflation changed all that, with central banks now having no choice but to exit from unconventional monetary policies. As once repressed and highly artificial interest rates have begun to rise, bond vigilantes have woken up. The UK government’s recent fiscal slippage has given them an opening few could have foreseen. They are now looking beyond the UK. Significantly, their presence was felt in the German bond market on Monday, albeit in a much more subdued way. Rumors that the government would agree to Europe-wide bond issuance caused an immediate spike in yields there. While the size and shape of the spike was small compared to what the UK experienced, it was nonetheless remarkable to keen observers of European bond markets. Italian yields have also risen, both in absolute terms and relative to their more “risk-free” German counterparts, and in a more worrying way. The immediate cause was fears that the new government would not maintain fiscal discipline and, with that, its access to significant EU funding. Then there is the emerging world. There, vigilantes never really fell asleep like they did in advanced economies. But their influence has grown in a world where the sources of financial volatility come mostly from the core of the financial system anchored by a Federal Reserve that is struggling to contain inflation. In 1993, James Carville, the political consultant, said, “I used to think if there was reincarnation, I wanted to come back as president or pope or .400 baseball hitter. But now I want to come back as a bond market. You can intimidate everyone. Risky fiscal and monetary policies rattled the bond market watchmen and gave them reason to start doing what they were doing so effectively before they were suppressed by the prolonged period of unconventional central bank policies. The good news is that their actions will limit the kind of fiscal and monetary irresponsibility that can cause long-term damage to so many. The bad news is that their resurgence comes at a time when growth is weakening and financial fragility has arisen from central bank repression.

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