• The same bond yields got Truss sacked, but not Sunak
  • What is a bond vigilante?
  • Interest expense has become politically expensive

We all love a good vigilante story. The righteous vengeance that is usually denied to those who say, “I told you so.” But does that still apply to the bond vigilantes who brought down the UK government?

Back in October, the Truss-Kwarteng budget triggered a crash in UK government bonds, driving borrowing costs into the stratosphere. A stratosphere that they then returned to under the current government…

The bond market’s electoral power isn’t a new story. It’s just that governments are usually smart enough to back down in the face of the vigilantes’ threats early on. Even Greece and Italy’s wild leaders eventually gave in to financiers’ demands during the European Sovereign Debt Crisis and its echo in 2018.

One Italian politician put it like this: “In a way I am very happy because we have finally wiped the bull**** off the table. We now know that it is a choice between democracy or comfortable bond spreads.” The Italians, like the Conservative Party, chose bond spreads.

Clinton political adviser James Carville famously said this about the bond market in 1994, too:

I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.

Those who think we live in democracies forget that they also run out of other people’s money eventually, if a bit slower than socialism does. In the end, those with the money run the party because they decide how long it can continue.

During the European Sovereign Debt Crisis, European governments complained furiously, to nobody in particular, that they were beholden to yield spreads on sovereign debts rather than their own voters. Southern European politicians suspected that the attacks on their bonds were orchestrated to pressure them to reach a settlement with Northern Europe… which they did.

But since then, central bankers have been busy backing bond markets to make sure nobody falls out of bed. With the notable exception of Liz Truss (Italian Prime Minister Giorgia Meloni and French politician Marine Le Pen had better take note).

The question now is whether the era of selective stability is over thanks to inflation constraining what central banks can do in the bond market. And, if it is, then the vigilant vengeance of the bond vigilantes’ vendetta might have begun.

What’s a bond vigilante?

Well, governments rely on someone in the private sector being stupid enough to finance them. Printing money is, after all, known to be a really, really bad idea. At least it was in the era of bond vigilantes…

When governments make bad decisions, the willingness of the private sector to finance their budgets ebbs, resulting in higher interest rates. Some, anticipating this, bet it will happen. And, just as short sellers are demonised in the stock market, bond sellers are demonised as bond vigilantes.

Both short sellers and bond vigilantes can actually move markets, it is worth pointing out. But vigilantes get their powerful reputation by forcing governments to see the error of their ways before those errors play out. They undermine political promises before they can be broken by harsh reality. That’s why politicians hate bond vigilantes. And why they are a healthy thing for a political system to have.

Because of this dynamic, interest rates are like political polling from the financial sector. A government that’s on a dangerous trajectory gets charged higher rates by lenders. If things get bad enough, the government can struggle to get any financing at all.

Politics is almost a game of balancing the two factors – managing polling numbers among the voters against the interest rates in the bond market. Spend too little and your polling numbers fall. Spend too much and your interest rates rise.

All of this held fairly true until the central banks forgot that money printing is taboo and causes inflation. Which happens periodically, historically speaking. It’s not like this is the first time that governments have resorted to money printing to finance their deficits.

But there’s a particular reason why bond vigilantes might finally manage to make a comeback soon. Inflation has set into motion the re-emergence of a painful old friend – interest rates above 0%.

Suddenly, the amount of debt actually matters again. The interest bill shows up on the budget alongside the usual issues which sway the polling numbers, like the NHS, defence and welfare.

Unfortunately for today’s politicians, interest gets paid first. And so they’re fighting over a falling supply of what’s left to dish out among citizens to purchase votes. The higher the interest bill, the more difficult it is to buy votes.

And it’s not like the electorate is understanding or forgiving of the issue. They, like central bankers, think money grows on trees.

The underlying financial risk is that, if central banks are perceived to be not only financing the government’s budget but financing its interest bill as well, then you begin to get a self-sustaining spiral.

The more that inflation goes up, the more that interest rates go up, the more that the interest expense of the government rises, the more that the central bank must print money to finance the government, the more inflation you get. Round and round we go, where we stop the bond vigilantes don’t stick around to find out – they sell.

Having the central bank monetise (buy) the government’s debt and deficit didn’t matter as much when interest rates were low because the practice didn’t have quite the same self-sustaining spiral dynamic. There was no interest to monetise.

Until recently, the threat of higher rates hasn’t mattered much because inflation rates were so low. But now inflation has forced central banks to raise interest rates higher. And so now the interest bill is growing as a portion of government budgets. If central banks continue to finance governments that get into trouble, the vicious cycle of long-term inflation could be awakened.

An attempt to reverse the cycle means a budget surplus which repays debt. Something I doubt is politically viable.

This situation has also reawakened the bond vigilantes because it suggests a bond crash may yet play out, despite the incredible control central banks exert over bond markets these days.

In Japan, for example, which is much further along the road that’s paved by printing money, the central bank has practically suspended the free market’s operations in the bond market. The bond vigilantes left to become currency vigilantes instead, sending the yen crashing last year.

In countries where central banks have less credibility, the bond vigilantes have been busy, too. Argentina, Ghana and Sri Lanka are good examples of where financiers have called out a government by being unwilling to finance it.

These phenomena may soon start appearing in bond markets near you. And this time, it won’t be part of a deliberate attempt to unseat a prime minister. Not a politically motivated one, but a financial one.

Politicians had better get their central bank digital currencies (CBDCs) ready before then. Or they could lose control over your money.

Which is precisely what we recommend you do.

Until next time,

Nick Hubble
Editor, Fortune & Freedom