Oct 1, 2023

Why vigilantes are again stalking the US bond market Three decades ago, bond vigilantes pushed the US government into cutting budget deficits. This time around, the task is harder, regardless of how high bond yields climb. Share They’re back! The bond vigilantes who reigned supreme three decades ago, punishing Washington for running up yawning budget deficits by dumping US government bonds, are once again flexing their financial muscles. Billionaire investor Bill Ackman says investors are not being paid enough to enter into a 30-year contract with the US government David Rowe A major sell-off in the US bond market has pushed the yield on US 10-year bonds – a key measure of the cost of borrowing for the US government and the benchmark for global interest rates – to 4.6 per cent, its highest level since 2007. (Yields rise as bond prices fall.) Since July last year, the yield on US 10-year bonds has climbed roughly 2 percentage points, amid growing investor disquiet that the US government budget deficit is ballooning, at a time of robust economic activity. This is an eerie replay of what happened three decades ago when bond vigilantes orchestrated a widespread selling campaign of US government bonds, as a way of pressuring Washington to embrace fiscal discipline. Advertisement This sell-off caused the yield on US 10-year bonds to jump from around 5.2 per cent in late 1993 to more than 8 per cent a year later. Investors who placed bets against US government bonds are already reaping handsome profits from the steep slide in long-term bond prices. Back in early August, Bill Ackman, the high-profile US hedge fund billionaire disclosed on X, the social media platform formerly known as Twitter, that his firm was shorting US 30-year government bonds, given the outlook for persistently high inflation, and the large US budget deficits “as far as the eye can see”. Last week, he repeated his warning on US government bonds. “Our view is, you’re not being paid enough to enter into a 30-year contract with the US government at a fixed price of 4.7 per cent,” he told a conference in New York. Ackman’s comments are a bitter reminder that the era of ultra-low interest rates, when governments, corporates and consumers could borrow with impunity, have now ended. Advertisement The steep rise in interest rates since early 2022 mean that investors are taking a much dimmer view of debt-laden borrowers. US budget deficit will double Bond markets are alarmed to see that the US deficit ballooned to $US1.5 trillion ($2.3 trillion) in the first 11 months of the US fiscal year, which runs from October, at a time when the US economy is at full employment. US government spending is growing at a pace that is unprecedented except during recessions and the Vietnam War. At the same time, US government revenues have fallen, as the 2022 US share market rout resulted in lower capital gains tax collections. Further, most of the increased spending has been in routine areas, such as healthcare, social security, military, education and paying the higher interest bill on the US government’s massive $US33 trillion of debt. Economists now expect the US budget deficit will double to roughly 7.5 per cent of US GDP, of which 2.5 percentage points is due to the higher interest bill. Advertisement Indeed, the surge in US borrowing costs means that interest expense will absorb about 15 per cent of total US government revenues. But while investors and economists agree that US budget deficits are excessive for an economy that is enjoying solid growth, whittling back the deficits will be difficult. Roughly two-thirds of US government spending is mandatory, and spending pressures will continue to rise as the population ages. And the combination of persistently high inflation and large budget deficits means the US government’s interest costs will remain high. Meanwhile, US corporate borrowers are increasingly feeling the sting of higher borrowing costs. Many corporates are locked in long-term debt, taking advantage of the ultra-low interest rates that were available in the pandemic period. For instance, only about 10 per cent of the $US1.5 trillion junk bond market has been refinanced this year. But the longer rates remain high, the more borrowers will have to roll over their debt at much higher interest rates . Advertisement