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'Vigilantes' neutered as bond market ignores soaring US debt

On March 1, the U.S. government failed to meet its deadline for raising the debt ceiling, raising the possibility of defaulting on obligations. The bond market shrugged.

The response was similar when Congress passed tax breaks that are projected to add nearly $2 trillion to the deficit and as U.S. debt more than doubled from 2008 to 2018, to $21.5 trillion, or 104% of GDP.

The "bond vigilantes," capital markets' guardians of fiscal responsibility, have lost their power in the U.S. as the market takes its cues from more activist central banks and inflation data. That contrasts with their roles in events such as the European debt crisis, when soaring bond yields in Greece, Italy and Spain prompted action from governments and the European Central Bank to bring the rates down.

"The reason bond yields remain puzzlingly low in the face of what everybody knows is the deteriorating outlook for the U.S. deficit is [that] obviously doesn't matter right now," said Ed Yardeni, who coined the term "bond vigilantes" in the 1980s to refer to investors who sold their holdings in response to fiscal indiscipline. "What matters is inflation and the Fed's policies."

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Bond vigilantes made their presence felt in the U.S. during Bill Clinton's presidency when 10-year Treasury yields were pushed above 8% from October 1993 to November 1994 in response to concerns over profligate government spending. After the government took steps to reduce the deficit, the yield dropped to about 4% by November 1998.

Clinton political adviser James Carville responded by saying: "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."

Since starting 2018 at 2.46%, yields on U.S. 10-year Treasurys rose as high as 3.22% at the Nov. 6 close, according to S&P Capital IQ data, as the Fed raised its benchmark rate to between 2.25% and 2.5% in December 2018 before Fed Chairman Jerome Powell signaled a pause in rate increases. President Donald Trump has no such concerns. The tax cuts from his administration passed in 2017 will increase the projected deficit by roughly $1.9 trillion between 2018 and 2028, according to the Congressional Budget Office.

The benchmark U.S. yield has closed as high as 15.15% in October 1981 and as low as 1.38% in July 2016. It was at 2.65% at 6:45 a.m. ET.

"Central bankers have trumped the ability of the bond vigilantes to have much impact, simply because the central banks have been buying so many bonds and keeping interest rates so low," Yardeni said.

Through its quantitative easing purchases that started in response to the financial crisis, the Fed bought roughly $1.98 trillion of Treasurys between March 2009 and October 2014, bulking up its balance sheet to roughly $4.5 trillion. The central bank began trimming its Treasury and mortgage-backed-securities holdings in October 2017. It now holds roughly $2.17 trillion in Treasury securities, down from $2.5 trillion in October 2017, according to Fed data.

Biggest game in town

The size and scope of the U.S. economy also diminishes the sway bond vigilantes have over markets.

"It's much, much harder to attack [a] government security that is the main safe asset of the global financial system," said Christopher Smart, who heads macroeconomic and geopolitical research at Barings. U.S. debt acts as a rising tide for the bond market during good times and serves as a safe harbor during downturns, he said. "It's hard to imagine a scenario where things fall apart."

Despite rising debt totals, the U.S. fiscal position relative to other large, developed countries also makes its debt outlook less bleak. Japan's debt-to-GDP ratio sat at 233.7% in 2017, according to data from the Organisation for Economic Co-operation and Development. The debt-to-GDP ratio was 116.3% in the United Kingdom and 109% in Canada.

More recent vigilante targets, including Greece and Italy, had debt-to-GDP ratios of 189% and 153%, respectively, as of 2017.

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'No leadership to be seen'

Such considerations were not a factor when S&P Global Ratings became the first major rating agency to strip the U.S. of its AAA grade on Aug. 5, 2011, citing concerns about the U.S. defaulting if it did not raise its statutory federal debt limit.

Even then, the 10-year Treasury yield ended the month 62 basis points lower, at 2.15%, S&P Capital IQ data shows.

The possibility of a technical default due to a failure to raise the debt limit may be eradicated if legislation to repeal it altogether goes ahead as indicated by Steny Hoyer, the No. 2 Democrat in the House of Representatives, who told reporters last month that he told Treasury Secretary Steven Mnuchin he supports extending and repealing the debt limit.

As for whether lawmakers start focusing on bringing down the deficit, economist Douglas Holtz-Eakin, a former Congressional Budget Office director and the president of the center-right think tank American Action Forum, does not expect anyone to step up anytime soon.

"The old adage is you make change either by leadership or by crisis," he said. "There's no leadership to be seen, so crisis is the choice at the moment."