Bond Market Trumps the President

"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."

James Carville – political advisor to Bill Clinton

For the first time in over two decades, global debt markets – not just central banks – are contributing to setting the rules. This shift has implications for all investors, but particularly those with significant fixed income exposure. Let’s look at how we got here, and what today’s market looks like for global investors.

A brief history of bond vigilantes

Jump back with me thirty years into the past. It’s the 1990s and then U.S. President Bill Clinton is trying to institute policies which, among various outcomes, would also serve to increase the U.S. national debt. His efforts were not thwarted by a robust Congress or skilled Republican politicking, but it was storied “bond vigilantes” that forced the president to switch gears and focus on the deficit.

Bond vigilantes are not caped crusaders seeking justice. They are quiet men and women, quietly reviewing economic data, quietly forecasting an economic outlook of fiscal policy, and quietly deciding that they will not invest their clients’ money in government bonds unless they are offered a higher yield.

Around a decade later, and for most of the subsequent twenty years, central banks in the U.S. and throughout the Western world stepped in to stabilize a global economy rocked by a collapse in collateralized debt, a collapse of major financial institutions, floundering confidence and a global pandemic. They purchased large quantities of national debt without regard for economic return. With such heavy intervention of central bank buying, bond vigilantes faded into the background like a Sasquatch in the Rockies.

Today’s market dynamics

Fast forward to today, central banks have disposed of much of their exceptional debt purchases.  Without their demand propping up the market, we see yields on U.S. Treasuries returning to early 2000s levels (see figure 1). With big non-economic players out of the way, bond vigilantes are back in action.

Figure 1: U.S. Treasury yields return to early 2000 levels (yield on 30-yr U.S. Treasury)

Source: Bloomberg

For decades, the U.S. has pursued a foreign policy of promoting democracy, trade, and rule of law, providing military support that helped Western allies prosper. Citizens have become wealthier, and have used some of that wealth to buy U.S. goods and services and invest in U.S. property and securities, making U.S. Treasuries and the U.S. dollar preeminent safe assets. Being the global safe asset has granted the U.S. greater leeway with respect to national debt levels and preferential interest rates. It has been a beneficial relationship with wealth shared among all parties.

Dealing with an economic superpower, like the U.S., means it may pursue a strategy of pushing its advantage to increase its own wealth regardless of the impact on others. We have recently witnessed an obvious shift in U.S. foreign policy with a bias toward isolationism, and a much more mercantilist approach to trade.

In April, Trump announced his new “reciprocal” tariff policy, raising tariffs on all countries that currently are – or are considering – exporting goods to America. The bond market saw these new tariffs as a threat to global trade and the economy, reducing foreign demand for U.S. Treasuries and dollars. The safety premium afforded to U.S. Treasuries was diminished, with investors demanding higher yields for long-term U.S. Treasuries. In Trump’s words, the bond market got “yippy”. Shortly after being announced, reciprocal tariffs were substantially reduced for a 90-day period of review. The bond market won again.

What this means for investors

What happens next? Particularly, what happens next for investors who look at national debt outside the U.S.? The Russian invasion of Ukraine, combined with U.S. isolationism, will result in greater military spending by non-U.S. countries. This increases national debt and should put upwards pressure on yields on non-U.S. countries. But if U.S. Treasuries are deemed riskier, some of the investment that would have gone to U.S. securities will instead go elsewhere, potentially this will help to keep foreign yields contained at the expense of higher U.S. bond yields.

With increased trade protectionism in the U.S., other countries can look to increase trade among themselves, and more importantly, reduce trade barriers within their own borders. The bond market has passed judgment on U.S. fiscal policies. There still appear to be avenues for non-U.S. policies to be set that are less disturbing to their respective bond markets.

Securities markets are good at reviewing future economic outcomes. Bond markets are particularly good at reviewing national debt and the risks associated with timely inflation-adjusted repayment. With the bond market no longer suppressed by central banks, this marks a new era of fixed income. U.S. Treasuries are still a safe haven, but not invulnerable. Overall U.S. assets will remain as an important component of portfolios, but the reign of significant year in and year out outperformance may be coming to an end.

Source: Bloomberg

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