As the US presidential election nears, the bond market braces for a potential resurgence of the “bond vigilantes.” With fiscal deficits reaching unprecedented levels, there is growing concern that neither major party candidate has a viable plan to address the mounting debt burden.
Edward Yardeni, former chief strategist at Oak Associates, Deutsche Bank, and Prudential Financial and the man who coined the term, warns that the bond market could impose its own discipline if political leaders continue to falter.
By selling government bonds en masse, bond traders can drive up interest rates, increasing borrowing costs for governments and pressuring them to reduce deficits and adopt conservative fiscal policies.
Deficits
Historically, the largest deficits occurred during recessions when tax receipts fell and government spending on income support increased. Today, the US deficit is soaring even as the economy grows, driven by massive fiscal stimulus, tax cuts, and spending increases.
In the past, deficits tended to widen in a recessionary environment where the Fed was lowering interest rates and inflation was moderating. So, that deficit cycle didn’t have an adverse impact on the bond market; in fact, some of the best bond rallies occurred when deficits were widening because it coincided with recessions and disinflation. That’s currently not the case, Yardeni explained in an interview with Investment Officer.
“We’ve never had deficits of this size, both in absolute terms and relative to GDP, while the economy is growing,” Yardeni noted. “We’re running deficits over a trillion dollars due to Trump’s tax cuts and Biden’s spending increases.”
Due to the Federal Reserve’s rate hikes to combat inflation, the cost of debt has also increased significantly. In 2024, the United States will spend $870 billion on interest payments, more than the country spends on its defence.
Donald Trump has pledged to erase the national debt of $34.6 trillion, though he has yet to outline a concrete strategy. In contrast, President Joe Biden introduced a budget aiming to slash the deficit by $3 trillion over the next decade, a proposal that failed to gain Congressional approval.
Political system is broken
Bill Gross, founder of Pimco, stated last week that a Donald Trump victory in the US presidential election would negatively impact global bond markets. He described a Republican win as more “disruptive” than Joe Biden’s re-election, predicting that Trump’s policies would worsen the US budget gap due to his advocacy for continued tax cuts.
“Somebody has to scream about the deficits,” Yardeni said, referencing vocal critics like Bill Gross and other Wall Street titans like Jamie Dimon and Ray Dalio.
“There is certainly no political constituency in Washington, D.C. to do anything about the deficit. We may very well need a financial crisis in this country for politicians to address the secular trend of the deficit. Everyone agrees that it’s an unsustainable course, but nobody agrees on what to do about it. The solution is very simple and obvious: raise taxes and lower outlays. But the political system is too broken right now for us to implement something that straightforward,” Yardeni said.
“The reason I’m fairly relaxed about it is that, yes, one day there could be a day of reckoning where auctions will be so terrible that bond yields will rise significantly. But the bonds will definitely get sold. The only question is at what yield.”
‘Sloppy’ auctions
The bond market has potentially started to react to this fiscal irresponsibility. Recent Treasury auctions have been “sloppy,” causing upward pressure on yields. Last week, the yield on Treasury notes hit its highest level in a month after a seven-year Treasury note auction, following a sell-off triggered by lacklustre two- and five-year auctions. The 10-year Treasury yield peaked at 4.64%, the highest since early May.
This raises the question of whether this is a simple supply and demand issue or if the market is finally recognising that current interest rates are where they need to be. “The Fed has normalised interest rates, and these rates are probably where they should be,” Yardeni asserted.
“They might not need to come down, and so the Fed will keep the Fed funds rate at this level. This obviously puts upward pressure on the two-year and ten-year rates to discount that fact, which is what we’re seeing now.”
Despite the debt’s size, it has remained manageable due to the robust US economy. The US’s 128 percent debt-to-GDP ratio is still average compared to other G7 nations.
Debt-to-GDP ratio of G7 countries
China
The bond market’s reaction to US fiscal policy isn’t just about domestic factors. International dynamics, such as tariffs on Chinese goods, play a crucial role according to Yardeni. Both Biden and Trump seem to agree on imposing more tariffs on China, which could have inflationary effects. Yardeni highlights that one reason the US has managed to reduce inflation without a recession is because China has been experiencing a recession.
“If we impose effective tariffs on Chinese goods, it might raise the import prices of goods in the United States and Europe. That could certainly be a problem for the bond market,” Yardeni warned.
Sweet spot
Despite these risks, Yardeni sees a silver lining in the current economic landscape. He believes the US may be in a “Nirvana” of sorts, with interest rates at a neutral level that supports economic growth without stoking inflation.
“We’re in the sweet spot now,” he said, particularly in the United States and in some emerging economies like Mexico, where the 10-year yield is around 10%.
“We saw the 10-year bond yield in the US rise to 5% in late October of last year, and there were still buyers,” Yardeni noted. “Anytime you can get in between 4.5% and 5%, I think that’s relatively attractive. Buying those would be my advice.”
The historical resilience of the market during presidential elections also bolsters investor confidence. The Bloomberg U.S. Aggregate Bond Index has posted positive returns in every presidential election year for the past 50 years, averaging gains of over 7%. This trend remains mostly independent of the electoral cycle.
Looking to Europe, Yardeni also sees potential opportunities as the European Central Bank might lower its official rates ahead of the Fed, benefiting the bond market there.
‘At some point, this will not be sustainable’
Edward Yardeni previously served as chief investment strategist of Oak Associates, Prudential Equity Group, and Deutsche Bank’s US equities division in New York City. Here is the transcript of his interview with Investment Officer:
IO: Are bond markets concerned about who’s in the White House?
Yardeni: Markets tune out what happens in D.C.. Despite the increasing partisanship of American politicians, investors have done well under Trump and have continued to do well under Biden.
That’s why management teams are paid the big bucks—they have to figure out how to stay in business and grow their enterprises even in an environment where the government’s influence is increasing in terms of revenue regulation and overall economic impact. Management seems to be doing a very good job of expanding their businesses and withstanding the meddling from Washington, D.C.
So my advice has traditionally been that while you can worry about partisanship, deficits, and fiscal and monetary policy, at the end of the day, it’s really about earnings and the valuation of those earnings.
Companies have done a very good job of consistently increasing their earnings, with the exception of recessions, which typically don’t last very long. As a general rule, politics hasn’t mattered much.
Every time we get near a presidential election, people say it’s the most consequential election we’ve ever had and that everything is at stake. Things might go a little crazy for a while, but the stock market continues to expand as long as the economy does the same.
With regard to both Biden and Trump, there’s very little they agree on, but they do seem to agree on imposing more tariffs on China. This could potentially have some inflationary impact. One reason we’ve been able to reduce inflation in the US without a recession is because China has been experiencing a recession for the rest of us.
IO: Europeans and Americans have learned over the years that the only way to bring inflation down is through a recession. The question is, does it have to be in the US or Europe, or would a recession in China suffice?
Yardeni: China has experienced a significant bursting of the speculative bubble in the property market and is relying on exports to keep its economy growing. They are doing this by increasing manufacturing capacity and exporting deflation with the goods they ship to the rest of the world. If we impose effective tariffs on Chinese goods, it might raise the import prices of goods in the United States and Europe. That could certainly be a problem for the bond market.
IO: Could it be a problem to the extent that the Fed will perhaps not be able to lower rates in the foreseeable future?
Yardeni: I think the Fed is coming around to a view I’ve had, which is, if the economy is growing and showing resilience, and inflation is moderating, why is it necessary to lower interest rates? Perhaps we’re actually in the “Nirvana” of the so-called neutral interest rate being exactly where it should be, or at least in the right neighborhood. At the end of the day, we don’t know exactly what the neutral interest rate is. The neutral interest rate is the rate at which the economy can grow with inflation remaining subdued. Well, that’s what we have now.
We’re in the sweet spot now. However, some Fed officials believe that if inflation continues to moderate and they don’t lower the Fed funds rate, the real Fed funds rate will rise, which could become restrictive. But that’s more theoretical than practical.
IO: We know that markets tend to ignore what happens in Washington, but multiple people have been talking about the effects on fiscal policies and the looming debt crisis in the US. What do you think about that?
Yardeni: Well, I’ve been doing this for over 40 years, and during that time, there’s been a lot of doom and gloom talk about deficits. Historically, the biggest deficits occurred during recessions because tax receipts would decrease while the government spent more on income support, like unemployment claims. In the past, deficits tended to widen in a recessionary environment where the Fed was lowering interest rates and inflation was moderating. So, that deficit cycle hasn’t had an adverse impact on the bond market; in fact, some of the best bond rallies occurred when deficits were widening because it coincided with recessions and disinflation.
In the current environment, we’ve never had deficits of this size, both in absolute terms and relative to GDP, while the economy is growing. One reason the economy is growing and didn’t fall into recession is because of all the fiscal stimulus. Nevertheless, we’re running deficits over a trillion dollars due to Trump’s tax cuts and Biden’s spending increases. There’s renewed talk about a day of reckoning, that at some point, this will not be sustainable. We just had three sloppy auctions that put some upward pressure on the bond market.
The question is whether that’s a supply and demand issue or if the market is coming around to a view I’ve had: the Fed has normalized interest rates, and these rates are where they should be. They don’t need to come down, and so the Fed will keep the Fed funds rate at this level. This obviously puts upward pressure on the two-year and ten-year rates to discount that fact, which is what we’re seeing now.
IO: Why do you think people like Bill Gross, Jamie Dimon, and Ray Dalio are so vocal about fiscal spending and a looming debt crisis?
Yardeni: Look, somebody has to scream about the deficits. There is certainly no political constituency in Washington, D.C. to do anything about them. The reason I’m fairly relaxed about it is that, yes, one day there could be a day of reckoning where auctions will be so terrible that bond yields will rise significantly. The bonds will get sold, and the only question is at what yield. If it’s at a yield that creates a financial crisis and we retrench into a recession, then what do we do?
We may very well need a financial crisis in this country for politicians to address the secular trend of the deficit. Everyone agrees that it’s an unsustainable course, but nobody agrees on what to do about it. The solution is very simple and obvious: raise taxes and lower outlays. But the political system is too broken right now for us to implement something that straightforward. So instead, we’ve got the worst of both worlds.
IO: And by “broken,” you mean there is no political incentive to change fiscal spending?
Yardeni: Correct, nobody is proposing deficit reduction in Washington, D.C. Instead, they’re proposing tax cuts or spending increases. Nobody is suggesting cutting outlays and decreasing the deficit.
IO: Is it true that you coined the term bond vigilantes? Is that a theoretical concept?
Yardeni: It’s simply an observation that there during the 1980s, we did see three episodes where there was renewed fears of inflation and bond yields. Rose and subsequently, nominal GDP growth slowed.
The idea is that if the fiscal and monetary authorities fail to maintain stability in the economy, then the bond vigilantes will step in to enforce discipline. This concept worked quite well in the 1980s. When Bill Clinton came into office in the early 1990s, he was advised to pursue fiscally conservative policies to avoid upsetting the bond market. Meanwhile, inflation came down.
The last significant intervention by the bond vigilantes was probably last year. Globally, a similar scenario occurred around 2010, when yields spiked up to 40%. In the United States, we saw the 10-year bond yield rise from 4 to 5 percent during August, September, and October in a very short period. This happened because the bond market was concerned that inflation wasn’t decreasing enough, the Fed would have to keep interest rates high, and the supply of bonds was outstripping demand.
However, on November 1, Secretary Yellen announced that she would reduce the issuance of longer-term notes and finance more of the deficit with short-term bills. This move was seen as an effort to take pressure off the bond market. Over the past 12 months, the Treasury raised $2.5 trillion, which is more than the deficit because they needed to replenish their checking account at the Fed. Of this amount, $1.9 trillion was raised through bills. This strategy by the Treasury is intended to avoid upsetting the bond vigilantes.
IO: Are you anticipating a return of the bond vigilantes around the upcoming elections?
Yardeni: I think it’s a risk. I’m not saying it’s the most likely scenario because I’m somewhat conflicted here. I really believe that inflation will continue to come down on its own. A lot of it was pandemic-related, and as those effects fade, we have seen inflation decreasing. This is partly due to the situation in China and also because rent inflation is likely to continue to decrease, along with other components slowing down. I think we’ll probably get down to a 2% inflation rate by the end of the year.
However, we are not going to make any progress on the deficit unless better-than-expected economic growth gives us some better revenues. Structurally, the deficit isn’t going away, and we’re not doing anything about it. At some point, there could be a day of reckoning, as people like Ray Dalio, Jamie Dimon, and Bill Gross have warned. They are right that it’s a problem.
But in terms of the performance of the bond market, one has to consider what’s happening with inflation, the role of the dollar, and US fixed-income securities in the global system. Despite talk about the dollar weakening, there are still plenty of foreigners buying US securities, including Treasuries.
IO: Our audience is portfolio managers at Dutch pension funds and insurance companies. Imagine you’re talking to someone with a global fixed income mandate who can invest freely. What should they do, in your opinion?
Yardeni: Given that I think disinflation will continue, the risk remains in protectionism and trade wars leading to significant tariffs and price increases. However, I see that as a risk rather than the most likely scenario. The most likely scenario on a global basis is that inflation will continue to moderate.
So, I view current bond yields as attractive, particularly in the United States, and maybe selectively in some emerging economies, like Mexico, where the 10-year yield is around 10%. That looks relatively attractive. I wouldn’t buy Chinese bonds at this point; they’ve had a big rally, and there could be some reversal as the Chinese economy starts to improve due to stimulus.
Additionally, it appears that the European Central Bank might lower its official rates ahead of the Fed, which could benefit the bond market in Europe.
IO: So does that mean that the potential risk, even if small, of a return of the bond vigilantes is a risk that European investors should consider at this point?
Yardeni: I’m sure European investors are very well aware of the bond vigilante issue, which is essentially too much supply relative to demand. We saw the 10-year bond yield in the US rise to 5% in late October of last year, and there were still buyers. So, there’s always going to be buyers; the question is at what yield, and what impact that will have on the economy.
I think the 10-year bond yield in the US will be in a wide range of 4% to 5% for the foreseeable future, similar to where we were before the Great Financial Crisis. Anytime you can get in between 4.5% and 5%, I think that’s relatively attractive. Buying those would be my advice.