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And Now Their Watch is Ended

August 3, 2020 3 comments

At one time, fiscal deficits mattered. There was a time when the bond market was anthropomorphized as a deficit-loathing scold who would push interest rates higher if asked to absorb too much new debt from the federal government. The ‘bond vigilantes’ were never an actual group, but as a whole (it was thought) the market would punish fiscal recklessness.

Of course, any article mentioning the bond vigilantes must include the classic account by Bob Woodward, describing how then-President Bill Clinton reacted to being told that running too-large deficits would cause interest rates to rise and tank the economy: “Clinton’s face turned red with anger and disbelief. ‘You mean to tell me that the success of the program and my re-election hinges on the Federal Reserve and a bunch of ****** bond traders?’”

Truth be told, this was always a bit of a crock in the big scheme of things. Although the bond market occasionally threw a tantrum when Big Government programs were announced, the bond traders have always been there when the actual paper hit the street. The chart below shows 10-year yields versus the rolling 12-month federal deficit. Far from being deficit scolds, bond market investors have always behaved more as if bonds were Giffen goods (whose price gets higher when there is more supply, and lower when there is less supply, in the opposite manner from ‘normal’ microeconomic dynamics). I guess so long as we are doing a walk down economic history lane, we could also say that the bond market followed a financial version of Say’s law: that supply creates its own demand…

Well, if ever there was a time for the market to get concerned about deficits, now is surely it. While the Fed continues to buy massive quantities of paper (to “ensure the smooth functioning of the markets”, as it surely does since if they were not buying such quantities the adjustment may be anything but smooth), there is still an enormous amount of Treasury debt in private hands. And it all yields far less than the rate of inflation. Clearly, these private investors are not alarmed by the three-trillion-dollar deficit, nor of the effect that the Fed buying a large chunk of it could have on the price level.

If investors are not alarmed by a $3T deficit – and, aside from market action being so benign, consider whether you’ve read any such alarm in the financial press – then it’s probably fair to say that there isn’t a deficit amount that would alarm them. Always before, if the market absorbed an extra-large deficit there was always at least the concern that it might choke on all that paper. Or, if it didn’t, that surely we were at the upper level of what could be absorbed. I don’t sense anything like the unease we’ve seen in prior deficit spikes. And that’s what alarms me. Because, as I tell my kids: a rule without enforcement means there isn’t a rule. Investors are not putting any limitation on the federal balance; ergo there is no limit.

Well, perhaps by itself that’s not a big deal. Heck, maybe deficits really don’t matter. But what bothers me is that the risk to that possibility is one-sided. If deficits don’t matter, then no biggie. But if they do matter, and the bond vigilantes are dead so that there is no push-back, no enforcement of that rule, then it follows that the only speed limit that will be enforced is when the car hits the tree. That is, if there is no alarm that causes the market to discipline the government spenders before there’s a crack-up, then eventually there will be a crack-up with 100% probability (again, assuming that deficits do matter at some level, and maybe they don’t).

While the vigilantes kept watch, there was scant worry that a government auction would fail. Although, as I’ve pointed out, the vigilantes weren’t macro-enforcers there were sometimes micro-aggressions: sudden interest rate adjustments where yields would jump 100bps in six weeks, say. This doesn’t happen any longer. So, while there’s plenty of money floating about right now to buy this zero-yielding debt, the larger the bond market gets the more of that money it will be sucking up. Unless, that is, the amount of money expands faster than the amount of debt (so that the debt shrinks in real terms), which is another way to say that the price level rises sharply. In that case, in order to keep the markets “orderly” the Federal Reserve will have to take more and more of that zero-yielding debt out of the market, replacing it with cash. It’s easy to see how that could spiral out of control quickly, as well.

I am not sure how close we are to such a crack-up. It could be years away; it could be weeks. But without the bond vigilantes, there’s no law in this town at all.

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