The return of the bond market vigilantes
In 1994, James Carville, a political adviser to President Clinton, famously remarked that if there were such a thing as reincarnation, he would like to be reincarnated as the bond market. By this he meant that he would like to wield the bond market’s immense power to discipline and rein in errant economic policymakers by driving up interest rates.
With growing signs that rising inflation is anything but transitory, as the Federal Reserve keeps assuring us, there are ominous signs that the bond market vigilantes might once again be saddling up. Indeed, over the last couple of months, 10-year U.S. Treasury bond yields have risen sharply to 1.6 percent, or to more than double their level last year. The continuation of the bond market sell-off could pose a serious challenge to the U.S. economic recovery by triggering the bursting of today’s “everything” asset price and credit market bubble.
The latest run-up in long-term bond yields suggest that the markets are not nearly as sanguine as is the Fed about the inflation outlook. Whereas the Fed believes that inflation will soon return to its 2 percent inflation target and that there will be no need to raise interest rates until 2023 to keep inflation in check, the markets seem to be fretting that the Fed could soon fall behind the inflation curve.
In seeming to be concerned about the inflation outlook, the markets seem to have in mind the many troubling tell-tale signs of future inflation. It is not only that world food prices have increased by over 30 percent. Or that ahead of the Northern Hemisphere winter natural gas prices are skyrocketing and international oil prices have more than doubled over the past year to around $80 a barrel. It is also that a policy-induced rapid increase in domestic aggregate demand is running into global supply chain problems and domestic labor shortages that could last longer than U.S. economic policymakers expect.
As if to underline this point, Asian producers are warning that the computer chip production problems plaguing the world automobile industry could last well into 2022 and perhaps 2023, while the world shipping industry is not expecting an early resolution of its problems that are clogging world ports and driving up world shipping costs at a disturbing rate.
Meanwhile, average hourly earnings in the U.S. are rising at more than a 4.5 percent clip. They are doing so as job openings have now risen to a record 10.5 million job openings, which far exceeds the 7.7 million unemployed workers to which the Fed keeps referring.
Should the bond market vigilantes sense that the Fed is going to remain slow in reacting to rising inflationary pressures, they must be expected to continue selling longer-dated U.S. Treasuries and driving up long-term interest rates. That in turn could trigger the bursting of the equity, housing and credit market bubbles both at home and abroad. This would seem to be especially the case considering that those bubbles have been premised on the assumption that long-term interest rates would stay at their currently low levels forever.
All of this would imply that the Fed can ill afford to allow itself to fall behind the inflation curve. The more that the Fed is perceived to be unduly passive about inflation, the higher the bond vigilantes are likely to drive up long-term interest rates on the expectation of higher future inflation. And the higher that long-term interest rates rise, the greater is the chance that the “everything” bubble bursts, which could cause real stress in both the U.S. and world financial systems. This is particularly true given that today’s global “everything” asset price and credit market bubble is much more pervasive than was the 2006 U.S. housing and credit market bubble.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.