Have the Bond Vigilantes Finally Arrived?

I used to think if there was reincarnation, I wanted to come back as the President or Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone
 – James Carville, Clinton campaign strategist

Like clockwork, financial commentators are emerging to declare the return of the so-called "bond vigilantes" -- an amorphous network of speculators that, in certain instances, wreak havoc on sovereign debt yields as they did on the other side of the Atlantic until the European Central Bank forcefully stepped in. A recent CNBC headline asked: Are bond vigilantes taking on the fed? And a blogger at Seeking Alpha wondered whether bond vigilantes will drive the 10-year above 2.06%?

What's gotten these commentators in a tizzy? At about this time last year, the interest rate on the 10-year Treasury bond bottomed out below 1.5%. Today, and particularly after a recent run-up, it's at 2.16%. In terms of basis points, that equates to a 44% increase in rates, and a concomitant decline in bond prices. That's a massive move for one of, if not, the largest and most liquid markets in the world.

But is there anything to the provocative headlines, or are they, as has been the case so often over the last few years, simply using the incendiary phrase to generate page views from readers like you? I'm sad to say, but it's probably the latter.

To provide some context, take a look at the chart below. It compares the frequency of Google searches for the term "bond vigilante" with the interest rate on the 10-year Treasury bond. While the correlation is far from perfect, this shows that the two biggest spikes in Google searches corresponded at least anecdotally to the two biggest increases in long-term interest rates.

Take April to June of 2009 as an example. Over these three months, the yield on the 10-year shot up from a monthly average of 2.93%, to 3.72%. Meanwhile, the incidence of Internet searches for "bond vigilantes" went from an index value of zero, all the way up to 86.

But what happened to interest rates after each of these instances? They went down, bottoming out, as I noted above, at less than 1.5% in the middle of last year. If the bond vigilantes were indeed on the prowl, in other words, they appear to have sauntered into the wrong town (cue Clint Eastwood, playing the role of sheriff, calmly awaiting their arrival).

I'll be the first to admit that it's exciting to attribute the market's volatility to the behind-the-scenes machinations of a loose confederation of international speculators. Saying that bond prices went down (and thus interest rates up) because investors are generally more confident in the state of the economy simply doesn't have the same pizzazz. Yet, at least when it comes to the recent fluctuations in long-term interest rates, the latter appears to be more closely aligned with reality.

To refer back to the chart above, it's no coincidence that the two times in which interest rates spiked most dramatically overlapped with an increasing sense of confidence in the economic recovery. In March of 2009, Ben Bernanke infamously told 60 Minutes that "green shoots" were starting to appear in different markets, and that "as some confidence begins to come back that will begin the positive dynamic that brings our economy back." And a second wave of confidence hit at the end of 2010, only to watch as riskier asset prices swooned six months later; for the latter, all you need to do is look at what happened to the Dow Jones Industrial Average (DJINDICES: ^DJI  ) or the S&P 500 (SNPINDEX: ^GSPC  ) in the middle of 2011.

Paul Krugman discussed this in a recent post on his blog, The Conscience of a Liberal.

[W]hen long-term interest rates rise, there are three main stories you hear. One is that the bond vigilantes have arrived, and are selling U.S. debt because they now believe in the horror stories. Another is that the Fed has changed, that it may be ready to snatch away the punch bowl sooner than previously believed. And the third is that the economy is looking stronger than expected, which means that the Fed, although just as soft-hearted as before, will nonetheless start raising rates sooner than previously believed.

All three of these stories would imply falling bond prices, that is, rising interest rates. But they have different implications for other markets, in particular for stocks and the dollar. Debt fears -- basically, a run on America -- should send stocks and the dollar down along with bonds. A perceived tougher Fed should send stocks down but the dollar up. And a better recovery should send both stocks up (because of higher expected profits) and drive the dollar higher. ...

And while day by day there are variations, basically what you see over the last month or so is [the third option]: falling bond prices accompanied by rising stocks and a rising dollar. So this looks like a story about macroeconomic optimism.

So, what's the point in all of this? The point is that there is neither now nor likely soon-to-be any type of legitimate threat to the government's borrowing costs from a wild posse of bond vigilantes. While these ostensibly rogue speculators may be able to muster a sufficient amount of capital to short the debt of Greece, Spain, or Portugal, for reasons beyond the scope of the current article, the United States simply isn't vulnerable to the same concerted actions.

As a result, the uptick in long-term interest rates should be interpreted to mean just what your standard macroeconomic textbook would suggest: that in the face of growing economic confidence, investors' risk aversion decreases, and they demand a higher yield from government bonds. Does this mean that the recovery is nearly complete? No. Not even close. But it does mean that the economy, at least for the time being, is headed in the right direction.

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