Revenge Of The Bond Vigilantes

The bulk of mainstream reporting on the carnage in the bond market continues to focus on the increasingly outdated narrative that it’s being driven by Fed expectations. But analysts are coming around to my view that government deficits are increasingly driving it. Three examples from the few days since that post:

Shutdowns Come and Go. Why Deficits Pose the Real and Present Danger.

Government Shutdown Averted. But Is That A Good Thing?

The Wall Street Journal
Rising Interest Rates Mean Deficits Finally Matter

For our purposes, “bond vigilantes” is merely a fanciful anthropomorphism for the basic economic principle of supply and demand applied to government debt. There is no posse of green-eyeshade-wearing, gun-toting financial cowboys conspiring against deficits, just natural market forces attempting to ration a finite body of capital.

What does this mean for the economy and the markets?

Let’s take the economy first. Fiscal policy will change. That doesn’t mean the government will have to pay off the debt, balance the budget, or even necessarily reduce deficits. It does mean the growth rate will come down. The emerging core problem isn’t merely the deficits themselves, but the total absence of restraint. Even incremental progress on this front would bring a notable measure of relief.

It is not possible to have affordable housing and low consumer inflation and fund a war with Russia and provide blank check subsidies for higher education and medical care and a green energy revolution etcetera. The fantasy will yield to reality.

This will almost certainly mean both spending restraint and tax increases. For the latter, a good place to start would be reversing the 2018 TCJA tax cuts for giant corporations. Spending restraint could start with making less war and more peace. Any of the tax reduction and spending increases of the past two administrations should be first on the table; but anything the nation was able to survive without until the year 2000 is a candidate for careful reexamination. The economy in the years prior to that in fact thrived compared with the direction it’s taken since. The bottom line is that some things will have to be let go.

Next the market implications. Following financial media lite’s monomaniacal obsession with when and how the Fed will or won’t next tweak policy won’t serve investors well. The Fed can create dollars, but it can’t create goods and services. This means it doesn’t power anything … it only controls the steering wheel that determines how much of the deficit burden is borne by falling bond prices and how much by the falling value of the dollar. So either rates rise and money becomes harder to borrow or the money loses purchasing power. Or, as anyone trying to buy a home or car knows, both.

For now, the Fed is prioritizing the value of the dollar. This means falling bond prices and rising rates. The bond market is however the master of the future value of present money, meaning the discount rate that investors implicitly or explicitly apply to future corporate earnings and dividends rises, pressuring stock prices lower.

The yield curve allocates this across all durations of financial assets. So as long duration bond yields rise, the longest duration stocks are affected most … this means “growth” stocks that are being valued on the basis of far in the future earnings. Shorter duration “value” stocks valued on nearer term cash flows are more affected by shorter term bond yields. The former have benefitted most from the multi-decade decline in yields and have the most to lose from its reversal. As we’ve argued many times before, the overwhelming majority of investors are far better served by watching the yield curve and letting the bond market handicap the Fed. 

The yield curve has been deeply inverted. As longer term yields have risen, this inversion has begun to grow less deep. At some point, shorter term yields will begin to fall … and well before the Fed begins to reduce its rate targets. This typically happens in an environment of weakening corporate profits. At that point, the certain cash flows from Treasury bonds become more sought after by investors relative to the uncertain cash flows from corporate securities including common stocks. And considering that stock prices haven’t even yet “caught down” with where bond prices are now, this opens a trap door under them.

Many analysts have been making the point that the benefits of stock-bond diversification are a thing of the past, pointing out that stock and bond correlations have risen. They certainly have, but extrapolating that into the future is rent with hazard. If they can go from a low correlation to a high correlation, they can go from a high correlation to a low correlation. So it behooves us to remain diversified. Especially in light of the foregoing. And that notably includes cash and short term Treasuries, which serve us well while stock and bond prices both are on the decline. Gold has been weak while the dollar has been strong, but the dollar has been strong because of high interest rates. Like everything else in the investment landscape, that too will change.

4 thoughts on “Revenge Of The Bond Vigilantes

  1. jk says:

    do you think that, over the historical record, commodities make for a better diversifier than bonds? or some combination of bonds and commodities? i suspect the latter is the case, all assuming you want a “lazy portfolio” of fixed allocations by asset class, rebalanced either by calendar and/or guardrails.

    the website offers info on this, but it is limited to data from 1970 or so iirc. [see, for example, and ] that means it doesn’t include the 1940’s, which i still consider the best analog to our current situation. and gold wasn’t free to trade in the u.s. until after 1971.

    1. Bill Terrell says:

      In the spirit of a picture is worth a thousand words, check out this annual SS chart. Forget the forecast part for the moment; look at the history. Bonds and Copper are almost like a picture of a mountain range and its reflection in a lake.


      One caveat is correlations are dependent on the length of sampling interval and become less reliable as you get more granular. Still, even on a daily level the odds favor opposing movement. Another is that past may not be prologue … although correlations tend to persist over time, in important ways there are no good precedents for the current juncture. Statistics without first principles are always suspect. FWIW SS thinks it persists.

      But with this negative correlation, copper is hard to beat for diversifying bonds. Industrial commodities in general would be as well.

      In practical application, a 50:50 mix of CPER and COMT would be my go-to for diversifying a Treasury-heavy ETF portfolio.

      Of all the physical commodities, gold has been the most notable exception as having the highest correlation with bonds. So in a physical commodity portfolio, copper tends to diversify gold.

      After copper and bonds, the rest of the correlations are less clear. So I think your intuition is spot on.

      For diversifying stocks, all of the above. Copper (more generally industrial commodities) usually correlates well with stocks. Bonds often do and often don’t. Sometimes all correlate, highlighting the diversification utility of cash.

      BTW good resource. Portfolio Charts is listed on our Model Portfolio Introduction page.

  2. Finster says:

    “For the latter, a good place to start would be reversing the 2018 TCJA tax cuts for giant corporations.”

    You betcha. I am no fan of high taxes, but this tax cut, billed as beneficial for the middle class, is about the worst piece of tax legislation in memory.

    I’m not even a fan of soak-the-rich tax schemes, but this reduced the tax rates paid by the biggest and richest corporations below those of many individuals.

    This includes Amazon, the online retailer which used its Fed-subsidized cheap capital to take over a sizable chunk of internet infrastructure in the form of cloud services. It’s taken over a big chunk of the television industry with its streaming and production business. Today news reports highlight its entry into the rocket launching business.

    It includes Apple, a computer and phone maker that now has also taken over a big chunk of the media industry. There has been talk of expanding into the automobile business. Google has mushroomed into the alpha and omega of the online advertising market. The social media giant Facebook so fancies creating a “metaverse” it renamed itself in its image. God complex anyone?

    Together they now control most of the media, not to mention their massive influence in Washington DC.

    None of these might be a problem in and of themselves, but their being subsidized through an inflation burden borne by average Americans is. What they haven’t been paying in taxes has been made up with money printed by the Fed and lent to the federal government. It’s a massive take-from-the-poor-to-give-to-the-rich scheme that had no place in “making America great again”.

    A graduated progressive tax rate schedule is good enough for individuals. But not for corporations?