‘Bond vigilantes’ could be described as the guardians of the money temple whose role is to protect our purchasing power. Of course, this is just a figure of speech. Actually, bond vigilantes are portfolio managers who, if they believe a central bank is too lax in policy, sell bonds causing long rates to rise. This offers better protection against inflation risk, but it also slows the economy and reduces the risk of inflationary drift. Following their intervention, the central bank may be forced to raise its official rate in order to restore its credibility.

These practices did take place at one time, but the world has long since changed. Structurally accommodating monetary policy, reflecting an inability of central banks to generate sufficient inflation, limited the role of the bond vigilantes, forcing them to accept negative real rates (in the United States) or, worse still, negative nominal rates (in the eurozone). The recent jump in US long rates suggests that bond vigilantes have returned to the fore.

Unlike the ‘Taper Tantrum‘ bond market crisis of May 2013, when Ben Bernanke raised the prospect of a reduction in the pace of purchase of treasury paper as part of the Federal Reserve‘s QE, the recent rise in interest rates was not caused by the comments of a Fed official. On the contrary, its Chair has assured Congress of the need to maintain a very flexible policy and expressed confidence that any acceleration in inflation would be limited and temporary. The recent rise in long rates could therefore be interpreted as the manifestation of anger (tantrum) in the bond market, resulting from endogenous dynamics, rather than a reaction to an exogenous shock. It can be interpreted as reflecting a certain degree of disappointment on the part of investors in relation to statements from the Federal Reserve that may seem ambiguous. According to its new strategy, it will accept a moderate and temporary overrun of its inflation target of 2%, but the exact definition of these two adjectives has not been provided. It also remains unclear how it would react were the target to be exceeded. Would there be a gradual tightening or a rapid one driven by the fear of an excessive rise in inflation?  The market may fear a firmer reaction, with Jerome Powell having explained to the Congress Committee that, if necessary, monetary policy would be modified – i.e. tightened – while adding that such a change would be signalled well in advance.

The real cause of the discomfort of the financial markets lies in the fact that they are faced with three major questions. Firstly, that of the new monetary strategy, which targets average inflation over an unspecified period, secondly, that of the economic recovery after a wholly atypical recession – a vigorous recovery causing bottlenecks or weak recovery, handicapped by hysteretic effects – and lastly, that of the inflationary impact of a huge budgetary stimulus programme ($1.9 trillion). On the latter point, there is a certain irony in noting that while the likelihood of a moderate acceleration in inflation – the objective of the central bank – has not been so high for a long time, the discomfort in the face of this prospect remains significant.

The Federal Reserve must hope that its forward guidance will remain credible enough to avoid a too large and premature rise in long rates. Such a dynamic would not be without consequences for the real sector, in particular on real estate through a rise in mortgage rates or even the cost of company financing – and would present a challenge for the Fed in terms of the approach to take: it is doubtful that more QE in a market suffering from an increase in inflationary expectations would be a good idea. It would not be the only central bank to question the appropriate response. The rise in US long rates has, as usual, had repercussions around the world. The Australian central bank intervened in the bond market as part of its policy of targeting the 3-year rate, while the ECB merely intervened verbally: it has not set a precise target for long rates but is closely monitoring their development and, if necessary, is prepared to react, notably through its quantitative easing programmes. This need to communicate somewhat insistently arises from the fact that financial cycles are largely synchronised, while business cycles between the United States and the eurozone in particular are currently out of sync. In other words, while the US economy is well enough placed to cope with a certain rise in long rates, in the eurozone, higher bond yields under US influence would create a headwind it could do without.

Published with the kind authorization of L’Agefi