The bond market has something to say again

Economist Chris Sims describes the Fed’s monetary policy actions in the 1970s as “stepping on a rake.” Three times, the Fed aggressively raised interest rates to fight inflation. Three times, inflation was temporarily subdued, only to come back stronger.

Sims attributed this to a feedback loop of higher interest rates causing higher deficits causing higher interest rates — a loop that can only be broken when investors believe the government has the will to balance its budget. Otherwise, rate hikes become counterproductively inflationary.

“Economic theory makes clear that in an environment of uncertainty about future fiscal policy, monetary policy instruments may lose potency or have perverse effects,” Sims explained.

Case in point: Fed Chair Paul Volcker appeared to have conquered inflation when his rate hikes got CPI to fall from 14% in 1980 to 3% in 1983. 

But the market was unconvinced: The yield on 30-year Treasurys in 1983 was 11%.

Long-term interest rates remained eight percentage points above inflation because investors were sure the government’s annual deficit of $200 billion would cause inflation to come roaring back — another rake handle to the face.

Capturing the mood, economist Ed Yardeni coined the term “Bond Vigilantes” that same year. “If the fiscal and monetary authorities won't regulate the economy,” he wrote, “the bond investors will.”

By keeping Treasury yields so far above inflation, the bond market was effectively demanding that the US government get its fiscal house in order.

It worked.

To bring interest rates down, Ronald Reagan raised taxes, cut spending, and raised the retirement age for Social Security. George Bush signed a law — PAYGO — dictating that any new entitlement spending or tax cuts had to be fully offset by spending cuts or tax increases elsewhere. Bill Clinton raised taxes on Social Security and cut spending on Medicare.

As a result, the US government ran an annual surplus in 1999, its first since 1969. 

The fiscal discipline was expected to continue.

In 2001, Alan Greenspan reported to Congress that “the highly desirable goal of paying off the federal debt is in reach before the end of the decade.”

Perhaps predictably, that turned out to be the high-water mark for fiscal responsibility in the US. The federal government has not run a surplus since.

How did the Vigilantes let this happen?

Bond Vigilantes are not real, unfortunately, so we can’t ask them what they were thinking. But the collective behavior of bond investors changed in ways that suggest the market became sanguine about government budget deficits.

Some combination of a global savings glut, a lack of investing alternatives, the rise of price-insensitive buyers (like China), and a deep faith in the Fed kept bond yields low despite ever-rising deficits. 

The change is easy to see: Before 2010, bond investors demanded yields far above inflation; afterward, they settled for yields at or below it.

The Vigilantes were taking a “long siesta,” Yardeni wrote in 2023. 

Another factor was investors’ lived experience.

In response to the Great Financial Crisis, the Obama administration borrowed $800 billion to support the economy and the Bernanke Fed printed $1.7 trillion to support markets.

Somehow, inflation went down. 

In June 2015, US CPI was -0.23%.

Deficits rose. Inflation fell. Concern evaporated. Increasingly, it was only economic think tanks, gold bugs, and Bitcoiners left to warn us about the dangers of deficit spending.

Until now.

With long-dated Treasury yields hitting 20-year highs this week, the Bond Vigilantes appear to be waking up from their two-decade slumber.

Can the Fed do something? 

When Paul Volcker took the fed funds rate all the way up to 20%, the ratio of federal debt-to-GDP was roughly 30%. Today, it’s 100%. 

This makes the feedback loop of higher interest rates leading to larger deficits leading to higher interest rates turn much faster.

Every rate hike, designed to cool demand, instead injects billions in interest income into the economy, turning an ostensible monetary tightening into fiscal stimulus.

With the US government now spending over $1 trillion servicing its debt each year, Chris Sims’ proverbial rake handle will hit us in the face pretty much instantaneously.

The Fed, in other words, can do little if anything about inflation.

That leaves the job to Congress — which is not interested in doing it. There is no political will — on either side of the aisle — to return to the 1990s playbook of placating bond markets with some combination of higher taxes and lower spending.

What’s changed? 25 years of low inflation, political polarization, and economic disinformation appear to have undermined the government’s ability to make hard choices.

Few of today’s voters believe they should pay more in taxes, especially when it’s in the name of lowering interest rates. And there are not nearly enough billionaires to raise taxes on to make much of a difference.

There is no longer a constituency for lower spending, either — perhaps because the single largest contributor to federal spending is “payments to individuals.” 

Good luck to the politician who proposes reducing their constituents' Social Security or Medicare payments.

Unless voters have a change of heart, there seems little chance of Congress doing anything about the deficit (and therefore inflation).  

Can AI do something?

The federal debt is so big — $40 trillion now — it’s become demotivating. Why take the political risks or make the economic sacrifices for something that feels like an exercise in futility?

But maybe we could grow our way out of it?

AI raises the beguiling prospect of a painless fix: If LLMs increase productivity sufficiently, government revenue might increase so rapidly that no taxes need be raised or spending cut.

Alas, a recent paper suggests this is more hope than strategy.

If AI dramatically raises productivity, it seems likely to dramatically lower employment. If so, increased government revenue would be offset by increased welfare spending.

AI advances in healthcare are likely to result in longer lifespans, increasing the government's Social Security and Medicare expenses.

AI advances in military applications are likely to start a new arms race among governments (the very least productive kind of spending). 

AI is already raising borrowing costs as data center builders compete for scarce capital with the government, increasing the government's interest expenses.

Far from solving the debt problem, AI might even exacerbate it. 

This leaves us with just one option: financial repression.

The last disciplinarian

The financial repression that Bitcoiners have long predicted might have begun last week when Secretary Scott Bessent announced that the Treasury was buying long-dated US government debt.

Bessent pitched this as “liquidity management,” but the market viewed it as a thinly veiled attempt to force interest rates lower.

Stanley Druckenmiller, for example, called the measure “price management” and an attempt at "artificial yield suppression.”

No one thinks it will work: Treasury yields were back at their 20-year highs the day after the announcement.

Druckenmiller thinks that, if anything, it will make things worse: “Every basis point of artificial yield suppression is a subsidy to procrastination.” 

The message from the bond market is that it’s time to stop procrastinating.

“The long-term Treasury yield is the most important price in the world,” Druckenmiller concludes. “It is also the only fiscal disciplinarian the US has left.”

— Byron Gilliam

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