The turmoil in the U.K. bond market threatens not only the stability of the country’s financial system but also the economic and social well-being of most of its citizens. It is a situation that is going from bad to worse, and other countries must watch it carefully. Underpinning the recent disruption is the reemergence of the bond vigilantes—a debt-disciplining financial force that, long repressed, is starting to reassert itself.
The U.K. narrative is well known by now. A “government in a hurry” goes all out and promises not just protection from higher energy prices for both households and companies and growth-enhancing structural reforms but also large unfunded tax cuts. It does so in the context of a global increase in borrowing costs. Not surprisingly, markets push back strongly against the implied increases in the amount of debt, interest payments and debt-to-GDP ratio. The resulting sharp surge in yields exposes the significant fragility of a pension system that resorted to financial engineering to enhance returns.
Given the threat of financial and economic contagion, the Bank of England has no choice but to intervene in a manner contrary to its continuing mission to reduce high inflation. The government does a partial U-turn, but it’s not meaningful enough to improve the dynamics in play in a sustainable way. The resulting market calm quickly gives way to more turmoil, forcing an expansion of the BOE’s intervention.
It is tempting to think that the underlying market dynamics are limited to the U.K. They are not. They risk extending in varying degrees to a growing number of countries around the world, including those traditionally viewed as the strongest, such as Germany.
What we are seeing is the return of the so-called bond vigilantes. Their de facto role is to impose debt discipline. Their ammunition is stepping back from the purchase of bonds issued by those they deem to be misbehaving. Their strength comes from the threat of financial disruptions contaminating economic and social well-being. Their weakness comes from their tendency to overshoot.
These vigilantes had been deeply repressed by more than a decade of unconventional monetary policies—that is, interest rates floored at zero and huge and recurring central bank purchases of bonds. Unable to withstand such force, they slumbered. Their inattention was rational, and they were largely forgotten by bond issuers.
High and persistent inflation has changed all this as central banks now have no choice but to exit unconventional monetary policies. As once-repressed and highly artificial interest rates started moving up, bond vigilantes awakened. The recent U.K. government fiscal slippage provided them with an opening few of them could have foreseen. They are now looking beyond the U.K.
Significantly, their presence was felt in the German bond market on Monday, albeit in a much milder way. Rumors of the government agreeing to European-wide issuance of bonds caused an immediate spike in yields there. While the size and shape of the spike was small compared with what the U.K. has experienced, it was nevertheless notable for close watchers of European bond markets.
Italian yields have also been moving up, both in absolute terms and relative to their more “risk-free” German counterparts, and in a more worrisome manner. The proximate cause has been concern that the new government would not maintain fiscal discipline and, with that, its access to large European funding.
Then there is the emerging world. There, the vigilantes never really went to sleep completely as they did in advanced economies. But their influence has increased in a world where the sources of financial volatility come mainly from the core of the financial system that is anchored by a Federal Reserve scrambling to contain inflation.
In 1993, James Carville, the political consultant, famously said: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.” Risky fiscal and monetary policies have stirred the bond market vigilantes and given them reason to start doing what they did so effectively before they were repressed by the prolonged period of unconventional central bank policies.
The good news is that their actions will limit the type of fiscal and monetary irresponsibility that can cause long-term harm to so many. The bad news is that their resurgence is coming at a time of weakening growth and financial fragility borne itself of the central bank repression.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of The Only Game in Town.
This article was provided by Bloomberg News.