The Trump administration’s tax plan — and its disregard for the effect it would have on the federal budget deficit — is certain to pique the interest of a long-dormant segment of bond investors.
So-called bond vigilantes, once feared for enforcing restraint on spendthrift governments, have struggled to flex their muscles in recent years as global central banks stepped in to buy a glut of sovereign debt. Now may be the time for a comeback, with the Federal Reserve talking about trimming its Treasury holdings while the administration’s tax plan could spur more borrowing to cover a shortfall (assuming the projected economic growth doesn’t materialize).
The notion of the bond market holding elected officials to task is of course met with skepticism, given Barack Obama more than doubled the U.S. marketable debt over his two terms as president, to almost $14 trillion. And that burden is poised to nearly double again over the next decade, according to estimates by the Congressional Budget Office that don’t factor in Donald Trump’s fiscal initiatives. His budget director said in a Bloomberg Television interview last week that “deficits are not driving the discussion.”
“While the White House appears likely to rely on optimistic growth assumptions to offset most of the fiscal effects of the proposed tax cut, Congress will not be able to do so,” Goldman Sachs Group Inc. strategists led by Jan Hatzius wrote in a note Thursday. “Indications of openness to a tax cut among congressional Republicans suggest that a tax cut is more likely than revenue-neutral reform. We expect a long road ahead.”
Here are four indicators to monitor as the tax legislation progresses to gauge whether the bond vigilantes are back at it.
Term Premium
“Bond vigilantes are now clearly showing no signs of vigilantism,” said Edward Yardeni, president of Yardeni Research Inc. in New York, who’s been following the bond market since the 1970s. He coined the term “bond vigilantes” in the 1980s to describe investors who sell bonds to protest monetary or fiscal policies they consider inflationary.
Perhaps no metric better shows that than the 10-year term premium. Over the past 50 years, it’s almost always been positive because investors demand extra compensation to lock up their money in longer-dated securities. Yet after a brief time in positive territory after Trump’s election win, it’s negative once more, suggesting investors can’t see any risks on the horizon that would push yields higher.
Should the swelling national debt come to the forefront once again, the term premium should revert back toward it’s 50- year average of 1.81 percentage points.
Yield Curve
The spread between short- and long-dated Treasuries tells a similar story.
“The yield curve has been remarkably consistent as an indicator for the business cycle,” Yardeni said. “We still need to keep a watch on the yield curve — if it ever inverts, that would be a signal, as it has in the past, that we are imminently or soon falling into a recession.”
Recession aside, the yield curve indicates that investors don’t see much risk of inflation on the horizon, which would erode the value of their fixed-income payments. It also shows a lack of confidence that interest rates will move much higher in the years ahead.
If the yield curve makes a sustained break steeper, it could signal mounting concerns about the size of the national debt, and the prospect for inflation to ease the burden.
Break-Even Rates
“The bond vigilantes get much more excited about inflation than they do about the supply of government securities,” Yardeni said. “We are trained that market prices are dictated by supply and demand, so having bigger and bigger deficits should matter.
It does matter to bond vigilantes, but much more weight seems to be given to inflation.”
The best way to capture market-based inflation expectations over the long term is through the yield spread between 30-year U.S. Treasury bonds and similar-maturity Treasury Inflation Protected Securities, or TIPS. Last week it fell below 2 percentage points for the first time since Nov. 9, the day after the presidential election. It remains below the five-year average.
The U.S. is barely at the Fed’s 2 percent target for price growth. It’s no Zimbabwe, which is among the most-cited examples of hyperinflation.
Gold Allies
Those who feel massive inflation is inevitable as the U.S.
debt burden grows tend to favor assets like gold instead.
In some ways, gold bugs and bond vigilantes are kindred spirits. So it follows that they’ve both been suppressed in recent years. Gold futures trade at about $1,266 an ounce, down from as high as $1,920.70 during after the debt-ceiling crisis in August 2011 that led S&P Global Ratings to downgrade the U.S.
Since the financial crisis “the bond vigilantes have been pretty quiet,” Yardeni said.
Bloomberg: April 27, 2017
