Bond vigilantes — how investors are calling the shots on government fiscal agendas

20 Oct 2022

The UK has felt the full force of bond vigilantes, and they have successfully made Liz Truss the shortest-serving British prime minister in history. Fortunately, the SA government — shortly due to unveil its medium-term budget — is more likely to get a vote of confidence from bond investors.

So-called “bond vigilantes”, a term introduced by Ed Yardeni in the 1980s, have been having a field day in the UK, holding firm on their resounding vote of no confidence in Liz Truss’ economic plan.

It’s a sharp reminder to other countries that if any government’s fiscal plan falls out of favour with bond investors, they too could fall prey to the havoc wreaked on forex, bond and equity markets or suffer an equally disruptive market wipeout.

Yardeni, president of Yardeni Research, points out that it has been decades since bond vigilantes were last active. Remarkably subdued inflation from the mid-1990s through to 2020 meant they have laid low since the early 1990s. Now, however, he says: They’re Baaack!

Yardeni attributes the return of these investor activists to the fact that fiscal policies have remained expansive, even though monetary policies have become restrictive to bring soaring inflation in line.

“Once central banks were forced to stop their Great Financial Repression, the bond vigilantes were set loose.”

Competing priorities

At the heart of the problem is that governments and central banks are trying to address competing priorities. Central banks are doing their utmost to bring down inflation before it becomes entrenched, while politicians are trying to secure their political futures by alleviating the impact of a cost-of-living crisis on their populations.

Shielding their voters from high energy prices has become a top priority for the major developed economies most affected by rising energy costs: the US, UK and the Eurozone.

In the US, Biden is releasing strategic oil reserves ahead of the mid-term elections and the UK and Euro area are putting in place measures to cap energy prices — likely to be at a significant cost to the government.

The UK has borne the brunt of bond vigilante actions because the new prime minister and now-fired Kwasi Kwarteng ignored the fiscal realities brought on by a new higher-for-longer interest rate era after already having racked up a lofty 99.6% debt-to-GDP ratio.

However, all advanced country governments will no longer be able to fund their debt cheaply, as they did in the wake of the 2008 financial crisis when massive quantitative easing programmes brought bond yields down to historically low levels.

In the US, two-year treasury yields have moved above 4.5% and 10 years’ above 4.5% — and liquidity is in short supply. That’s worrying when the US national government debt-to-GDP ratio is nearing 130% and gross national debt exceeded $31-trillion for the first time in early October.

According to the Peter G Peterson Foundation, the implications of reaching this debt milestone are that interest costs are set to increase by almost $8.1-trillion over the next decade, compared with interest costs of $352-billion in 2021. It notes that the US spends as much or more on net interest costs than on Medicaid and Income Security programmes.

SA ‘in calmer waters’

For once, South Africa looks in a relatively more benign fiscal position ahead of its 2022 medium-term budget policy statement later this month, with economists describing SA’s fiscal position as “relatively benign, having avoided a fiscal cliff in 2021”, according to Investec Treasury Economist Tertia Jacobs, and “meaningfully better” than its February Budget Review, according to BNP Paribas South Africa senior economist, Jeff Schultz.

However, just as it’s the political pressures that are primarily responsible for putting fiscal sustainability at risk globally, it’s important to consider whether National Treasury will be able to withstand political pressures as it works towards stabilising the gross debt-to-GDP ratio at 75% over the three-year Medium-Term Economic Framework period.

Schultz addresses the risks of fiscal populism in South Africa and the likelihood that President Cyril Ramphosa will be tempted into profligate spending on public sector wages to retain support for his bid for a second term at that December conference.

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He says that BNP Paribas’ political base case is benign and doesn’t include the risk of populist spending.

Says Schultz: “While it is prudent to note those risks, we are relatively confident that the government will keep its head. Some slippage in public sector wage negotiations may occur, but this is unlikely to blow out the fiscal consolidation path.”

Another margin of safety for bond investors is that, as Jacobs points out, a high country-risk premium compared with other emerging markets is already embedded in SA government bonds, and thus, investors are being adequately compensated for any potential fiscal risks that may arise.

Globally, bond vigilantes aside, global bond yields are offering compelling yields on short-duration Treasury yields — which are 2.5 times the dividend yield on the S&P 500 Index — according to equity market dividend-yielding stocks.

Thus investors looking to take advantage of the opportunities bond vigilantes have inadvertently created in what she calls a “new normal” of higher interest rates and longer-run inflation, will benefit from decent relative income in the face of slowing economic growth.

That’s as long as other governments don’t pull an ill-considered UK fiscal stunt on us. BM/DM

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Competing priorities

SA ‘in calmer waters’