We have not heard from the “bond vigilantes” in quite some time. The origin of the word vigilante is Spanish for watchman, alert, or guard, and like a watchman they have been out there waiting for the long combination of events. The definition of bond vigilantes is a broad term for bond market participants who impose discipline on the market through focusing on negative fundamentals. Their form of discipline is selling duration or not buying at current levels.
Unfortunately, bond vigilantes have more in common with the grim reaper. They only come out when there is perceived death and destruction in the bond market and are never found lurking around in market rallies. In reality, these vigilantes are closer to Old Testament prophets preaching for repentance from the past ways of excess before there is a market failure. What makes them different from the prophets of old is that they dollars that can impose repentance. For now, we will keep with the well-used vigilante metaphor as they drive a wave of higher rates into town.
For most of the post Financial Crisis, the bond vigilantes have been held in check by central banks that have controlled rates and the supply of bonds through their active QE programs. Perhaps the last great vigilante signal was the taper tantrum in 2013.
Now times are different. Private debt investors can now impose discipline on markets when in the past any shortfall in their buying would be offset by the buying of central banks. If bond vigilantes don’t like the environment or current prices, they will sell or stop buying until the market clears at a better price. They are the marginal buyers and are watchful of negative events that will make bonds bad investments:
- Inflation which is moving closer to the 2% target and has been trending or threatening to move higher.
- Economic growth which moved ahead of expectations across the globe and is associated with a tightening of the labor market in the US.
- Central banks that are “normalizing” balance sheets and generating an upward bias to rates.
- The fact that there is no risk bond premium and a normalization will lead to a positive risk premium with higher rates.
- Consumer finance and balance sheets that have improved but are generating higher delinquency in selected sectors like student loans.
- Large government deficits caused from a tax cut and increased fiscal spending.
Rate markets may have gotten ahead of themselves given the strong upward momentum over the last few weeks, but the issues that are on the forefront of bond vigilante thinking will not change with any one economic number or in the near future.