Two friends had an interesting conversation after watching the movie “Seven Heroes”
Memory: There are currently seven major technology stocks in the stock market, as well as seven major technology artificial intelligence stocks.
Waynea: Haha.. not only that, but you also have vigilantes in the financial market, like the characters played by the seven protagonists in the movie.
Memory: how? Where?
Wiener: “Bond vigilantes,” they seem to be back.
Memory: who are they?
Wiener: Bond vigilantes are bond investors/traders who are vigilant about inflation and fiscal deficit trends. So if governments don’t do their job through responsible spending, bond vigilantes may end up forcing them to do so.
Memory: How a Bond vigilante can coerce a powerful government?
Wiener: Bond vigilantes sell government bonds when they are convinced that the government’s fiscal deficit exceeds a certain percentage of GDP, which could lead to inflation, thereby increasing bond yields. Yield is the bond’s annual interest divided by the bond’s price. So when bond prices fall due to selling pressure, yields rise, which becomes the benchmark for new government bond issuance.
Higher yields will lead to higher interest costs for the government. So instead of putting money to better use, the government spends a greater percentage of revenue on interest payments. It doesn’t do anyone any good. A further rise in government bond yields affects not only the government, but also businesses and individuals, as their borrowing costs are also tied to the government’s borrowing costs. After all, governments are the least risky borrowers, so the rest of the country tends to be more expensive to borrow than governments, although there are some exceptions. This will also have a negative impact on stock valuations.
Memory: Hmm.. Interesting, but what’s the need to be aggressive and sell?
Wiener: Bond investors seek compensation in proportion to the risk they take in investing in bonds. When they invest in government bonds, the risk of default is extremely low, but they face duration risk. The value of a currency depreciates over time as inflation erodes its value. Therefore, the longer the bond maturity, the greater the risk of inflation, especially when government spending could cause inflation to exceed tolerable levels. In this case, bond investors seek higher compensation (i.e., higher yields) for their investments. The bond vigilante sale sends a message to the government to watch their actions.
There are many examples of bond vigilantes putting pressure on governments to act together, such as during the Greek/Eurozone crisis in 2009-10, India’s high fiscal deficit/high inflation period in 2012-13, and of course last year in the UK, which ultimately overthrew Leeds Truss government. More recently, they have taken action in the US, Europe, and to some extent Japan. In the US, selling pressure sent 10-year Treasury yields hitting 15-year highs last week as inflation concerns persisted.
India is also likely to keep a close eye on inflation trends and RBI/government actions in the coming months.
Memory: Ok, but why am I only hearing about this term now?
Wiener: ha! Quantitative easing by global central banks after the 2007-08 financial crisis hit the bond vigilante hard in the decade 2010-20. While they have succeeded in a handful of emerging markets, they have been on the losing side in developed markets. Even the debt crisis sparked by Greece spread to other countries in the euro zone, where yields were suppressed after the European Central Bank began an aggressive quantitative easing program in 2012.
Many bond vigilantes shorting government bonds expecting yields to spike due to monetary and fiscal stimulus burned their fingers. Aggressive central bank buying has kept bond yields low and, surprisingly, inflation has not spiked for long. But now, in a new world order of constant inflation, deglobalization and excessive government debt in many countries, the bond vigilantes may be looking forward to their day in the sun!
