Bond Vigilantes are driving US, UK, Europe and emerging market bond yields higher. Have you heard of them?

Two friends got into an interesting conversation after watching the movie ‘The Magnificent Seven’

Ram: Now you have the Magnificent Seven in stock markets also with the group of seven big tech AI stocks.

Veena: Ha ha..not only that, you also have vigilantes in the financial markets like the role played by the seven main characters in the movie.

Ram: How? Where?

Veena: The ‘Bond Vigilantes’, they appear to be back in action.

Ram: Who are they?

Veena: Bond Vigilantes are bond investors/traders who keep a vigil on inflation and fiscal deficit trends. Thus if governments don’t do  their jobs by spending responsibly, the bond vigilantes may force them to do so finally.

Ram: How can the Bond Vigilantes force powerful governments?

Veena: When they are convinced the fiscal deficits incurred by the government beyond a certain percentage of GDP can be inflationary, the Bond Vigilantes sell the government bonds sending the yield on bonds higher. The yield is the annual quantum of interest on the bond divided by the bond price. Hence when the bond prices fall due to selling pressure, the yields increase, and this will be the benchmark for new bonds issued by the government.

Higher yields will result in higher interest cost for the government. Thus instead of putting money to better use, governments will be using a greater percentage of its receipts for interest payments. This serves no body’s purpose. Further increase in government bond yields impacts not just the government, but also corporates and individuals as their borrowing costs are also linked to government borrowing costs. Afterall government is the least risky borrower, so the borrowing costs for others in the country tends to be higher than that of the government, though there can be a few exceptions. This will also negatively impact equity valuations.

Ram: Hmm..interesting, but what is the need to get aggressive and sell?

Veena: Bond investors seek compensation proportionate to the risk they take for investing in a bond. When they invest in government bonds the default risk is extremely low, but they face duration risk. The value of money deflates with time as inflation erodes its worth. Thus the longer the duration of the bond, the greater the inflation risk especially when government spending can send inflation beyond a tolerable level. In such cases the bond investors seek higher compensation (ie higher yields) for their investment. Selling by bond vigilantes sends a message to governments and makes them take  note of their actions.

There are many instances of bond vigilantes pressurising governments to get their acts together like during Greece/Eurozone crisis of 2009-10, high fiscal deficit/high inflation period in India in 2012-13 and ofcourse more recently in UK last year which final toppled the Liz Truss government. More recently they have been in action in US, Europe and to a certain extent in Japan as well. In US the 10 year bond yields hit a 15 year high level last week on selling pressure as inflation concerns remain.

In India too they may be closely watching how inflation trends over the coming months and what actions the RBI/government takes.  

Ram: Ok, but why am I hearing about this term only now?

Veena: Ha! The quantitative easing undertaken by central banks globally post the 2007-08 financial crisis bruised the Bond Vigilantes very badly in decade of 2010-20. While they were successful in few emerging markets, they were on the losing side in developed markets. Even in the Eurozone which had debt crisis triggered by Greece that spread to other countries as well, the yields were  suppressed after the ECB started its aggressive quantitative easing program in 2012.

Many of the Bond Vigilantes who shorted government bonds expecting the yields to spike due to monetary and fiscal stimulus burnt their fingers. Aggressive buying by central banks kept the bond yields low and surprisingly inflation also did not spike for a long time. But now in a new world order of persistent inflation, deglobalisation and excessively high government debts in many countries, the Bond Vigilantes may be looking forward to their time under the sun!