Bond Vigilantes: Behind the Curtain
Although bond markets may try to intimidate governments, monetary sovereigns only have themselves to fear.
Three years ago, Liz Truss managed to earn the ignominious title of shortest-serving UK prime minister after just 49 days in office. But while Truss may have been ousted by her own party, the proximate cause of her downfall was not purely political. Instead, it was the result of a deeply unpopular fiscal package that spooked both credit markets and policy analysts alike.
The Truss ‘mini-budget’ had called for increased public spending financed largely with higher debt issuance. To investors looking at a public debt-to-GDP ratio of nearly 100%, this seemed like a sure sign of fiscal irresponsibility. The ensuing government debt sell-off led to a spike in yields and a brief period of financial chaos, followed shortly after by the prime minister’s resignation.
For politicians, the Truss episode underscored an age-old rule of political survival: don’t cross the bond market. As the logic goes, so-called ‘bond vigilantes’ are capable of punishing free-spending governments by selling off existing debt holdings en masse and refusing to finance new obligations. With British yields spiking once again this week and media rumors circulating on the return of vigilantism, you can excuse the current Labour government for being a bit jumpy.1
In reality, however, UK politicians don’t have much to fear from credit markets. Looking behind the curtain, bond vigilantes have no real mechanisms to inflict the damage they appear to threaten. Although investors can attempt to intimidate governments, monetary sovereigns only have themselves to fear.
The Logic of Bond Vigilantes
When governments spend more than they collect in taxes, they typically make up the difference by issuing sovereign debt purchased by private investors. If a government runs persistent fiscal deficits, this borrowing can climb to enormous levels relative to the size of the country’s economy. Eventually, investors may get nervous that the government could default on its obligations, especially following announcements of expansionary fiscal policy. It is at this point that some investors turn to vigilantism, selling off their debt holdings due to the perception that a government has borrowed more than it can manage.2
This selling drives bond prices down, which drives bond yields up. As vigilante logic goes, this increase in yield makes it more expensive for the government to borrow money, since investors will demand that interest rates on new debt rise to match market yields. The threat of perpetually rising interest rates translating into unsustainable debt servicing costs is why bond markets are seen as being able to push governments into curtailing their spending plans. Former presidential advisor James Carville once quipped that if he were reincarnated, he’d like to come back as the bond market - “You can intimidate everybody.”
In a recent article highlighting the firm’s views on US government debt, bond giant PIMCO summed up the logic driving vigilantism quite simply:
[W]e have become more hesitant to lend longer term given U.S. debt sustainability questions… The U.S. remains in a unique position because the dollar is the global reserve currency and Treasuries are the global reserve asset. But at some point, if you borrow too much, lenders may question your ability to pay it all back. It doesn’t take a vigilante to point that out.
To their supporters, bond vigilantes are seen as blameless market participants helping the invisible hand provide an essential check on reckless government spending. To their critics, bond vigilantes are seen as greedy financial institutions and speculators bullying the government into adopting their preferred policy positions. Almost no one, however, doubts the ability and the power of the bond market to discipline governments.
What the Vigilante Argument Misses
Vigilante logic certainly appears compelling. And, like all great lies, it does contain a hint of the truth - in some countries, government policies genuinely are at the whim of the bond market. In countries like the US and the UK, however, the bond market is only as powerful as politicians believe it to be.
Vigilante logic rests on the idea that governments need to borrow money in order to pay for expenses that exceed the amount raised in tax revenue. In reality, however, countries that print their own currency never actually need to borrow money, even if they choose to do so.3 Such countries are called ‘monetary sovereigns,’ and their ranks include the US and the UK.
To monetary sovereigns, domestic currency is an unlimited resource. The Bank of England (BoE), for instance, can create new pounds in the form of electronic reserves with nothing more than a few clicks on the computer. As such, monetary sovereigns are never truly reliant on bond markets to fund their spending. This also helps explain why the aforementioned PIMCO analysis rests on false assumptions. There’s no such thing as borrowing ‘too much’ when a debtor can create the very resource that they’re borrowing.
Crucially, this analysis does not apply to countries that lack full monetary sovereignty. That includes countries with a fixed exchange rate regime (like Saudi Arabia), countries that use a foreign currency (like France), and countries with significant debts denominated in a foreign currency (like Argentina). These countries cannot simply create new money to pay down their debts, meaning they must be cognizant of debt servicing costs and are thus subject to punishment by bond vigilantes.
The idea that monetary sovereigns face resource constraints in their own currency, however, is a pernicious misunderstanding that manifests in various ways. A recent report from Deutsche Bank, for instance, argued that the UK is particularly vulnerable to debt sell-offs because of the country’s large current account deficit (i.e., money tends to flow out of the UK each year due to the country’s international transactions). According to the analysts, this makes the UK reliant on foreign financing for domestic debt issuance.
But it’s odd to think that the UK government (which can create pounds) would ever rely on foreign investors (who cannot) to purchase its pound-denominated debt. If anything, foreign investors are reliant on the UK to keep issuing gilts so that they have a safe place to recycle their pound earnings, not the other way around. No matter how high the interest bill, currency-creating governments can always come up with the money to pay it.
A Note on Interest Rates
A slightly more technical section that addresses a nuanced counterargument. Casual readers can skip.
Another argument holds that while monetary sovereigns may never actually face currency shortfalls due to higher yields and rising debt service costs, bond vigilantes can still inflict economic punishment. Yields on government debt are typically the benchmark by which rates across an entire domestic economy are set. This means that when vigilantes drive up yields, they push up rates not just for the government, but for the entire country.
It is generally accepted (although far from proven) that higher interest rates are linked to slower economic growth by making it more expensive for people to finance new purchases. Thus, even monetary sovereigns may need to pay attention to yields to ensure that vigilantes don’t drive their country into recession. Just as monetary sovereigns can control domestic currency, however, they can also control domestic interest rates.
One thing to note about bond vigilantism is that it only ever seems to affect the far end of the yield curve. In fact, although yields on long-dated UK gilts have risen in the past few weeks, the 3-month bill yield has continued to trade around 4.75%. It is no coincidence that this is the exact same level as the BoE’s main policy rate, dubbed the ‘bank rate.’
The bank rate is the shortest of short-term interest rates, applying to reserves held overnight by commercial banks in the UK. Because central bank reserves and 3-month gilts are both short-term government obligations and because commercial banks can freely trade 3-month gilts for reserves, their yields should roughly track each other. In other words, vigilantes are effectively incapable of driving up short-term yields because the BoE can peg short-term yields through an arbitrage relationship.
Farther along the yield curve, however, this logic begins to break down. Central bank reserves are far less similar to multi-year bonds, meaning that the current bank rate exerts less influence over longer-dated yields. Just because central banks have not historically targeted long-term rates, however, does not mean that they lack the tools to do so.
Most obviously, quantitative easing measures in both the UK and the US were designed to lower long-term yields by purchasing government bonds on the market. But central banks are also capable of exerting far more precise control. Japan’s former yield curve control regime included an explicit cap on 10-year Japanese bond yields.
The point is that while higher yields can potentially cause economic and financial damage, markets can only determine yields in monetarily sovereign countries as long as the government lets them. Just as central banks are capable of fixing short-term rates, they are also capable of fixing long-term ones. Allowing vigilantes to push up yields is a policy choice.
Conclusion: Self-Imposed Wounds
Bond markets can seem all-powerful, threatening governments with spiraling debt service costs and reduced access to funding. Because monetary sovereigns do not need to rely on private investors to supply currency or determine interest rates, however, these threats are hollow. But while bond vigilantes may ultimately be powerless, there is one party capable of punishing monetary sovereigns: their own governments.
Self-imposed rules, such as a requirement to limit deficits or borrowing levels, can force monetary sovereigns to adjust fiscal policy if borrowing costs jump. In fact, this seems to be at least part of the story in the UK. With higher interest bills putting pressure on Chancellor Rachel Reeves’ long-standing promise to balance the budget, forecasts show that spending cuts may be necessary. With UK growth slowing and the economy looking increasingly vulnerable to a recession, such cuts might come at exactly the wrong time.
For monetary sovereigns, any wounds stemming from such arbitrary constraints amount to nothing more than an own goal. While blaming the bond market for imposing fiscal discipline may be a convenient excuse, currency-issuing governments are immeasurably more powerful than private investors. Bond markets can intimidate politicians only to the extent that politicians allow themselves to be intimidated.
It’s worth noting that bond vigilantism in the UK (to the extent that it actually exists) is only part of the story right now. Government bond yields have risen globally, most notably in the US. Regardless of the source of yield increases, however, the narrative that such increases must constrain government budgets persists.
This story tells the logic of vigilantism as adherents believe it, but yields often rise for factors that are merely mistaken for vigilante activity. For instance, investors may sell bonds due to an increase in future policy rate expectations (owing to higher inflation forecasts) or an increase in the term premium (owing to higher policy uncertainty).
Why do governments borrow money at all if they don’t need to do so? There are three main answers: 1) It’s typically legally required, 2) modern financial markets need government debt in order to function, and 3) borrowing to fund spending likely eases inflationary pressures. This topic will be the subject of a future article.