Great Explanation of Why Inflation Is So Low

Interesting insight from clovisdad, a commenter on another website:

Let's use Japan as an example.   Cutting through the "old language" of bonds and interest rates, bond vigilantes, taxes and balanced budgets, the Japanese (Bank of Japan) has concluded it can simply print all the money the government needs to borrow; and it does.

So now what's wrong with deficits?   Well, we all know that too much money chasing too few goods would cause inflation, but there's not a lot of that.  Why not? Because these economic policies murder savers, so people are forced to cut back on their purchases and contract their lifestyles, thus no inflation; while the government feasts on cheap debt for its ever expanding power..

The real consequence is that government has found an unbounded means of expansion on the backs of the citizens, who are thereby proportionately impoverished.

There is no free lunch; but governments, including our own, are now eating ours.

Stockman: "Major Conflagration" Coming

"I think it's going to take a major dislocation in the bond market, a real conflagration on the part of the people who have to buy this debt, before the country wakes up."-- David Stockman, Budget Director, Reagan White House

Interest Rates Rise to Six-Month Highs

The bond sell-off has accelerated, causing interest rates to rise significantly.

Bond Market Punishes Tax Accord

from Barrons:
THE BIGGEST LOSERS in President Obama's deal with the Republican on taxes aren't the Democrats. It's the bond market.
Yields soared in the wake of the plan that will add upwards of $900 billion to the federal deficit, sending bond prices tumbling, especially in the municipal market.
The question then might be asked if higher borrowing costs, especially for the beleaguered state and local government sector and housing market, will offset the thrust from fiscal policy.
Notwithstanding how it was being played in the media, there was no "extension of the Bush tax cuts" in the deal made by Obama with Congressional Republicans. The tax-rate increases slated to take effect on Jan. 1 were staved off for two years, as most forecasters had assumed would happen. So, no surprise there.
For investors, the favorable 15% tax rates for long-term capital gains and qualified dividends also were extended. In addition, the proposed bipartisan calls for the estate tax to resume at 35% with a $5 million exclusion on Jan. 1, instead of the 55% rate on estates over $1 million, as current law calls for.
The other key parts of the deal were a one-year, two-percentage-point reduction in Social Security withholding taxes (FICA on your pay stub) and a 13-month extension of emergency unemployment benefits. Both are designed to spur the economy by increasing the tax-home pay of those who work and maintain spending by those who aren't.
But it's unlikely to help solve that crucial economic problem. Extending jobless benefits pays people to be unemployed, so more of them will be, all else being equal. Nomura chief U.S. economist David Resler estimates the jobless rate may be a full percentage point higher than what it would be absent the long-term benefits, according to a Bloomberg interview. Also, the FICA reduction affects the employee's portion, not the employer's share. Had this cost to employers been reduced, they would have more incentive to hire. So, it's likely that these proposals will fall short of spurring employment.
What is certain is that the tax proposals is the federal budget deficit will be higher than previous estimates, most of which assumed that the current tax rates would continue and the scheduled increases would not be imposed while joblessness hovered near 10%. JP Morgan's economists project a $1.5 trillion shortfall for the current fiscal year, up from their previous $1.2 trillion forecast. For fiscal 2012, their projection is up to $1.2 trillion, from $1.1 trillion, as the two-point-cut in payroll taxes is reversed.
Economists reckon the tax package will add one-half to a full percentage point to real growth in 2011, with estimates now falling in the 3%-4% range. The better growth prospects from the fiscal proposals reduce the chances the Federal Reserve will purchase more than the $600 billion in Treasuries it currently plans; indeed, the central bank could buy less if the economy picks up.
The potential for the Treasury to sell more securities to fund the larger deficit, plus the likelihood that the Fed could buy fewer notes, in more robustly growing economy sent yields soaring. The benchmark 10-year Treasury's yield jumped 24 basis points (hundredths of a percentage point), to 3.17%, a five-month; its price fell nearly two points, or $20 per $1,000 note.
Conversely, one of the day's big winners was the ProShares UltraShort 20+ Year Treasury fund (TBT), an exchange-traded fund that provides two times the inverse of the daily return of the long end of the Treasury market, which gained 4% on more than twice its daily average volume.
Especially hard hit again was the municipal market, which suffered from an omission from the tax deal -- the expected extension of the Build America Bond program, which expires at year-end. BABs are taxable securities issued by state and local governments that receive a 35% federal interest subsidy.
In the 19 months since the program started, some $164 billion of BABs has been issued, according to the Bond Buyer. BABs had siphoned that new-issue supply from the traditional market of tax-exempt muni bonds, thus bolstering their prices and lowering their yields. That prop will be removed after Jan. 1, which sent muni prices tumbling Tuesday.
The BABs program had proven to be an inefficient and costly subsidy for the federal government. Over the next 30 years, Washington may pay out upwards of $100 billion of interest subsidies on BABs. The original cost probably assumed taxes paid on the BABs' interest payments would offset the cost of the subsidies. But the bulk of BABs were purchased by investors who don't render taxes unto the Treasury -- retirement funds, endowments and foreign holders.
Traditional tax-free triple-A munis yielded 4.60% Tuesday, up sharply from 4.48% a day earlier, according to Ken Woods, head of Asset Preservation Advisors in Atlanta. That compares with 4.39% on a federally taxable 30-year Treasury. To a taxable investor in a combined 40% federal and state tax bracket, a 4.60% fully tax-free yield is equivalent to a 7.67% taxable yield -- significantly higher than medium-grade corporates.
Tax-free yields of 7% and more again became available from leveraged closed-end muni funds, the most aggressive vehicle for participating in the sector. That's equivalent to an 11.67% taxable yield for an investor in a 40% bracket -- vastly higher than junk corporates and greater than the historic return from riskier equities, and more than commensurate with the risks posed by the widely publicized pension-fund deficits in states such as Illinois and California.
The sharp rise in bond yields potentially could blunt the impact of the fiscal thrust from the tentative bipartisan tax deal. The 10-year Treasury yield is up a sharp 70 basis points, which is likely to push a 30-year fixed-rate conventional mortgage back toward 5% from 4.67%. Historically low mortgage rates did little to stimulate housing, and refinancings have slowed already.
States and localities, already reeling under budget pressures, hardly need higher borrowing costs. Every basis point rise in Treasury yields also translates into real bucks with trillion-dollar-plus deficits. Only corporations, which already having taken advantage of ultra-low borrowing costs and are flush with cash anyway, would be immune from an uptick in bond yields.
Perhaps the deadening effect of rising bond yields is what took the winds out of the stock market's sails Tuesday. The major averages had been up nearly 1% early in the session but gave back those gains as the fixed-income sector sank.
The bond vigilantes may undo some of what Obama and Congressional leaders have tried to accomplish.

European Debt Crisis Threatens to Engulf Even Germany

from UK Telegraph:

Credit default swaps (CDS) measuring risk on German, French and Dutch bonds have surged over recent days, rising significantly above the levels of non-EMU states in Scandinavia.

"Germany cannot keep paying for bail-outs without going bankrupt itself," said Professor Wilhelm Hankel, of Frankfurt University. "This is frightening people. You cannot find a bank safe deposit box in Germany because every single one has already been taken and stuffed with gold and silver. It is like an underground Switzerland within our borders. People have terrible memories of 1948 and 1923 when they lost their savings."

The refrain was picked up this week by German finance minister Wolfgang Schäuble. "We're not swimming in money, we're drowning in debts," he told the Bundestag.

While Germany's public and private debt is not extreme, it is very high for a country on the cusp of an acute ageing crisis. Adjusted for demographics, Germany is already one of the most indebted nations in the world.
Reports that EU officials are hatching plans to double the size of EU's €440bn (£373bn) rescue mechanism have inevitably caused outrage in Germany. Brussels has denied the claims, but the story has refused to die precisely because markets know the European Financial Stability Facility (EFSF) cannot cope with the all too possible event of a triple bail-out for Ireland, Portugal and Spain.
EU leaders hoped this moment would never come when they launched their "shock and awe" fund last May. The pledge alone was supposed to be enough. But EU proposals in late October for creditor "haircuts" have set off capital flight, or a "buyers' strike" in the words of Klaus Regling, head of the EFSF.
Those at the coal-face of the bond markets are certain Portugal will need a rescue. Spain is in danger as yields on 10-year bonds punch to a post-EMU record of 5.2pc.
Axel Weber, Bundesbank chief, seemed to concede this week that Portugal and Spain would need bail-outs when he said that EMU governments may have to put up more money to bolster the fund. "€750bn should be enough. If not, we could increase it. The governments will do what is necessary," he said.
Whether governments will, in fact, write a fresh cheque is open to question. Chancellor Angela Merkel would risk popular fury if she had to raise fresh funds for eurozone debtors at a time of welfare cuts in Germany. She faces a string of regional elections where her Christian Democrats are struggling.
Mr Weber rowed back on Thursday saying that a "worst-case scenario" of triple bail-outs would require a €140bn top-up for the fund. This assurance is unlikely to soothe investors already wondering how Italy could avoid contagion in such circumstances.
"Italy is in a lot of pain," said Stefano di Domizio, from Lombard Street Research. "Bond yields have been going up 10 basis points a day and spreads are now the highest since the launch of EMU. We're talking about €2 trillion of debt so Rome has to tap the market often, and that is the problem."
The great question is at what point Germany concludes that it cannot bear the mounting burden any longer. "I am worried that Germany's authorities are slowly losing sight of the European common good," said Jean-Claude Juncker, chair of Eurogroup finance ministers.
Europe's fate may be decided soon by the German constitutional court as it rules on a clutch of cases challenging the legality of the Greek bail-out, the EFSF machinery, and ECB bond purchases.
"There has been a clear violation of the law and no judge can ignore that," said Prof Hankel, a co-author of one of the complaints. "I am convinced the court will forbid future payments."
If he is right – we may learn in February – the EU debt crisis will take a dramatic new turn.

Bond Traders to Mr. Market: Something Wicked This Way Comes!

The market buzz is that the Fed will begin more quantitative easing next Tuesday when they meet.

Treasury yields continue to reach new all-time record lows literally every day. This is a sign of very deep concerns that something very ominously dark is coming. Since the treasury and currency markets are the most liquid in the world, I tend to give them more credence than the stock market. 

Bond Vigilantes Begin to Extract Their Pound of Flesh

SAN FRANCISCO (MarketWatch) -- The bond vigilantes are on the attack, and Greece may be only their first victim.

The world's most powerful bond investors have lost patience with governments that threw a public-sector party with money borrowed on the cheap and now are scrambling to pay debts and provide for their citizens.
Greece, with its cooked books and spendthrift ways, was an easy target for the vigilantes' guns, but Spain and Portugal also are under fire, and the bond-market masters are keeping a close eye on how the U.K. handles its finances. In fact, no government appears safe, not even the U.S.
"There's a tremendous clash between the bond vigilantes on one side and reckless governments on the other," said Ed Yardeni, president of Yardeni Research, an independent global-markets strategy firm. "The bond vigilantes are trying to establish some fiscal and monetary law and order."
Who, or what, are "bond vigilantes?" They are the bond market's heavy hitters, taking fiscal policy matters into their own hands. Yardeni coined the term in the summer of 1983, when Treasury holders smacked the U.S. over high deficits. Yardeni recognized these hedge funds, mutual funds, pension funds and other institutional investors as a fearsome mob, ready to pillory profligate politicians and lax central bankers.
"If the fiscal and monetary authorities won't regulate the economy, the bond investor will. The economy will be run by vigilantes in the credit markets," Yardeni noted then.

'Intimidate everybody'

Bond vigilante justice had its greatest reach in the early 1990s, when the Clinton Administration bowed to pressure over federal spending. Clinton adviser James Carville famously quipped at the time that he'd like to be reincarnated as the bond market, because "you can intimidate everybody."
Today, a new breed of bond vigilantes has saddled up. Using leverage and rapid, electronic trading, these buyers and sellers shoot first, ride on and don't look back. Their blunt message to governments: Clean your fiscal house or pay bondholders more for the money you need -- that is, if you can get it.
In addition to slipshod governments, vigilantes vilify the credit-rating agencies, which grade bonds' quality and risk, for failing to do their job properly.
Bill Gross, the co-chief investment officer of U.S. bond powerhouse Pimco and manager of the world's largest bond mutual-fund, Pimco Total Return (NASDAQ:PTTAX) blasted the rating services earlier this month, mocking Standard & Poor's Inc. for downgrading Spanish government debt one notch to AA and warning Spain of another possible downgrade.
"Oooh -- so tough!" Gross wrote with undisguised sarcasm in his May monthly commentary. "And believe it or not, [rating agencies] Moody's and Fitch still have [Spain's debt] as AAAs. Here's a country with 20% unemployment, a recent current account deficit of 10%, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels, and whose fate is increasingly dependent on the kindness of the [European Union] and the [International Monetary Fund] to bail them out. Some AAA!"
European leaders tried to downplay these bond-market assaults. After snubs from the European Central Bank and the EU, the vigilantes cracked their whip, savaging Greek, Spanish and Portuguese government debt and raking the euro, which is still under strain.
European politicians and policymakers, fearing the vigilantes could spark a continent-wide meltdown in credit and stocks, hastily cobbled a $1 trillion rescue package with IMF help that's being called "Euro-TARP," in reference to the Treasury rescue hatched in late 2008 to contain the U.S. financial system's meltdown.

Bridging the gap

Does Euro-Tarp placate the vigilantes? For the moment, perhaps, but not for long.
"Markets stop panicking when policymakers start panicking," wrote Michael Hartnett, chief global equity strategist at Bank of America Merrill Lynch, in a recent report on Europe's market turmoil.
"Bond-market vigilantes are glad that something was done, but clearly everything hasn't been resolved," added Zane Brown, a fixed income strategist at investment manager Lord Abbett. "If the EU thinks it's all one big, happy family, the vigilantes are telling them there are clear differences among EU members."
Those differences seem to resonate louder with European officials. Bridging the gap between the richer and poorer economies of the euro zone is a key to stabilizing the common currency, and a concern that German Chancellor Angela Merkel addressed this weekend.
"We've done no more than buy time for ourselves to clear up the differences in competitiveness and in budget deficits of individual euro zone countries," Merkel was quoted as saying on Saturday. "If we simply ignore this problem we won't be able to calm down this situation."
Indeed, while the Euro-TARP may be more stop-gap than solution, the EU is betting it will keep Greece from defaulting on its debt and act as a firewall against contagion.
Spain and Portugal, for instance, aren't waiting around; their governments are cutting public-sector wages and raising consumption and corporate taxes, with further and sharper austerity measures expected.
"Spain and Portugal saw what would happen, and they started acting," said Roger Aliaga-Diaz, a senior economist at mutual-fund giant Vanguard Group.
Added Yardeni, the market strategist: "Portugal and Spain have been given a stay of execution."
The bond market, meanwhile, is, in a word, vigilant. Pimco executives stated in April that the firm is investing in countries with stable debt, including Australia, Brazil, Canada and Germany, and have shunned Greece, Spain, Portugal and other countries on the euro zone's periphery -- known as "Club Med" or, more derisively, "PIIGS."
Moreover, there's growing apprehension that Europe's massive bailout will stoke inflation, crush the euro, and threaten the region's stalwarts. The feverish rush to own gold is directly related to investors' anxiety that the cost of rescuing Greece and other Mediterranean countries from default, coupled with stimulus spending in the U.S. and other developed nations, will wash the world with money and lead to inflation and higher interest rates.
"Policymakers are now forcefully using the balance sheets of the EU (ultimately Germany) and ECB to compensate for the debt excesses in the periphery (particularly Greece) and the related overexposure of European banks, Mohamed El-Erian, Pimco's chief executive, wrote in a mid-May commentary.
"An even larger use of central bank balance sheets, if it were to materialize, would provide only a temporary respite," added El-Erian, who shares the firm's chief investment officer title with Gross, "and the collateral damage and unintended consequences would be serious, including the impact on inflationary expectations."
Muscles flexed, bond vigilantes are also turning their sights on the U.K. and the newest resident of 10 Downing Street. "The bond vigilantes are going to see whether this new government, without a majority in Parliament, is going to be able to cut spending and the deficit," Yardeni said. "The U.K. may be next in line for some discipline by the bond vigilantes if the policymakers can't get their act together soon enough."
In some ways, though, Europe's sovereign debt crisis is a problem of the bond-market's own making. Consider that in March 2005, 30-year Greek bonds commanded a yield just 0.26 percentage points over considerably higher-quality German debt of similar maturity, where in a pre-euro world, the spread was expressed in double-digits. It's no stretch to say that bond buyers wrote a blank check to Greece and other questionable sovereign borrowers, which spent that money with a "play now, pay later" attitude.
But while there may be blame enough to go around, the situation is well past the tipping point.
"The vigilantes are going to keep all of this on a very short leash," said Marilyn Cohen, president of Envision Capital Management, a Los Angeles-based bond-investment manager. "They're emboldened and they juiced up rates on Greek debt until it was excruciating. They've slammed the euro until everybody is questioning its viability. This is going to be a market thriller, and I don't mean that in a good way."

Treasury Auction Trauma

That was one ugly auction. More worries of sovereign debt default in Europe. Both Greece and Portugal are in trouble now! The bond vigilantes are back in force today!

The Big Guys Begin to Cut Risk Exposure to U.S. Debt

from Bloomberg:
Jan. 4 (Bloomberg) -- Pacific Investment Management Co., which runs the world’s biggest bond fund, is cutting holdings of U.S. and U.K. debt as the two nations increase borrowing to record levels.
Pimco is “more cautious” on corporate bonds and holds fewer mortgage-backed securities than the percentages in the benchmarks it uses to gauge performance, wrote Paul McCulley, a portfolio manager and member of the investment committee, in his 2010 outlook. The company is also underweight Treasury Inflation Protected Securities, according to the report on Newport Beach, California-based Pimco’s Web site.
“This all leaves us with portfolios that appear, more than at other times, to be hugging the benchmarks with no bold positioning,” McCulley wrote. “We’re making a very active decision to run light on risk.”

Bond Market Doesn't Believe Good News

The bond market has historically been a better predictor of economic growth than the stock market.

from Bloomberg:
Aug. 31 (Bloomberg) -- The bond market isn’t buying all the optimism over the end of the global recession.
While the International Monetary Fund said last week the economic recovery will be faster than it forecast in July, investors pushed yields on government debt to the lowest level since April, according to the Merrill Lynch & Co. Global Sovereign Broad Market Plus Index. The gauge, which tracks $15.4 trillion of bonds worldwide, gained 0.73 percent this month, the most since 1.02 percent in March.
Debt investors can’t see a recovery strong enough to spur central bank interest rates anytime soon, especially with the Obama administration forecasting that unemployment in the U.S. - - the world’s largest economy -- will rise above 10 percent in the first quarter. After stripping out the effects of the U.S. government’s “cash for clunkers” program to buy new cars, consumer spending was unchanged in July, according to Commerce Department data released on Aug. 28.
“The bond market does not believe we will see rapid robust rates of growth,” said Jeffrey Caughron, an associate partner in Oklahoma City at The Baker Group Ltd., which advises community banks investing $20 billion. “The deleveraging of the consumer will act as a drag on growth, which will keep inflation to a minimum and interest rates relatively low.”
‘Bumpy Road’
Bond yields are lower now than when Federal Reserve Chairman Ben S. Bernanke said in an Aug. 21 speech at the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming, that “prospects for a return to growth in the near term appear good.” European Central Bank President Jean-Claude Trichet said that while the economy is no longer in “freefall,” it faces “a very bumpy road ahead.”

also from Bloomberg:
Aug. 31 (Bloomberg) -- Treasuries rose, heading for their first two-month gain this year, as Chinese stocks fell and investors added to bets the global financial crisis will slow the pace of inflation.
The difference between yields on 10-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices, narrowed for a sixth day, reaching 1.70 percentage points, from this month’s high of 2.05 points on Aug. 10. The spread has averaged 2.20 percentage points for the past five years.
“Low bond yields have become an international phenomenon, and one important element of this is subdued inflation,” said Don Smith, fixed-income strategist at ICAP Plc, the world biggest broker of trades between banks. “We are still in that twilight zone between recession and recovery.”

Bond Vigilantes Trying To Do Their Job

Treasury traders are finding it difficult to push treasuries down despite strong equities and fewer purchases by BRIC nations. This is significant because following Bernanke's testimony yesterday, interest rates dropped. Now, the bond vigilantes are trying to push interest rates higher again.

Vigilante's Revenge

from Lauren Steffy at the Houston Chronicle:
A New Breed of Vigilante

They are the dark knights of finance, the shadowy champions of responsible spending. Lurking on the dim edges of the bond market, they keep watch over the deficit. They are ... the bond vigilantes.

The term was coined in 1983 to describe global investors who, unhappy with rising U.S. spending, drive up bond yields, forcing government austerity. Unseen for 15 years, the bond vigilantes may be at work again as the nation faces a staggering $1.9 trillion deficit to fund a stimulus aimed at breaking the worst recession in decades.

Runaway spending fuels inflation, which is the enemy of bond investors, driving them away from government debt and the dollar. As a result, the government has to pay higher yields to woo them.

“The bond vigilantes are saying, ‘You better watch your spending, because we’re going to push rates higher,’ ” said Rick Kaplan, a portfolio manager with Houston-based Legacy Asset Management. “We’ve never printed this much money before. Our budget’s never been this out of whack. That’s bringing the vigilantes out in full force.”

Health care burden

The final straw may be health care reform. If President Barack Obama pursues his health care agenda, it may add as much as $500 billion in spending.

The last time the bond vigilantes swung into action, it was to gut Bill Clinton’s health care spending plan in the 1990s, forcing him to focus on deficit reduction. Now, however, the economy is much more precarious. The Federal Reserve wants to keep interest rates low to shore up the housing market and cut borrowing costs for businesses.

That’s why Fed Chairman Ben Bernanke recently told Congress that we had to address the deficit. He’s trying to talk down the bond market, Kaplan said.

Low mortgage rates have been a key focus of the Fed’s recovery plan, but the market has been moving the wrong way. Rates on a 30-year fixed-rate mortgage jumped as high as 5.45  percent last week from as low as 4.85 percent in April. At the same time, yields on the benchmark 10-year Treasury note rose as high as 3.9  percent, up from about 2.2 percent in January.

“That’s what’s got everybody freaked out,” Kaplan said.

False sense of recovery?

At least, those who are paying attention. Many investors are too busy looking at the stock market, where the roughly 40 percent rise in the Standard & Poor’s 500 Index since February may be creating a false sense of economic recovery.

“That’s the barometer, and I think that’s misleading,” Kaplan said.

Gold prices, for example, have risen 18 percent since January, a sign the market sees inflation on the horizon. That doesn’t bode well for Bernanke’s plans because if mortgage rates climb, housing prices will fall, prolonging the recession.

“He wants the economy to stay just where it is,” Kaplan said. “He has no interest in raising rates.”

On a tightrope

It’s a difficult tightrope for the Fed to walk. On the one hand, it’s injecting trillions into the economy to combat the recession while on the other trying to keep rates low and shrug off inflation.

Outside of the Fed’s machinations, the economy seems to have few catalysts for recovery. For the past two decades, the market has been driven by financial engineering, deregulation, lower taxes and technological improvements, none of which is going to save us now. Corporate earnings are weak, casting suspicion on the equities rally.

Against a backdrop of mounting debt and increased spending, frustrated investors have had enough.

So this may be a job for the bond vigilantes. The problem for consumers is the bond vigilantes aren’t so much heroes as mercenaries. They may succeed in putting the brakes on spending, but they won’t save us from higher borrowing costs or a lingering recession.

Loren Steffy is the Chronicle’s business columnist. His commentary appears Sundays, Wednesdays and Fridays. Contact him at loren.steffy@chron.com. His blog is at http://blogs.chron.com/lorensteffy/.

Bond Vigilantes Take Their Pound of Flesh

I thought this insight from bond veteran John Jansen was symbolic and typical of the current sentiment in the bond market:

"I would expect the market to erode further as investors and traders demand a concession from the taxpayers for the profligate level of debt issuance."

The American people can't continue their profligate ways without consequences. The pound of flesh is only beginning to hurt! It will hurt much more as time presses on! One consequence for everyone is that borrowing costs are rising, and not just for the U.S. government! Mortgage rates are rising, and I suspect that other credit costs will rise also as time passes. Isn't that what John just said?

Bond Vigilantes Are Back and Beating Obama's Fed

from Bloomberg:

By Liz Capo McCormick and Daniel Kruger

May 29 (Bloomberg) -- They’re back.

For the first time since another Democrat occupied the White House, investors from Beijing to Zurich are challenging a president’s attempts to revive the economy with record deficit spending. Fifteen years after forcing Bill Clinton to abandon his own stimulus plans, the so-called bond vigilantes are punishing Barack Obama for quadrupling the budget shortfall to $1.85 trillion. By driving up yields on U.S. debt, they are also threatening to derail Federal Reserve Chairman Ben S. Bernanke’s efforts to cut borrowing costs for businesses and consumers.

The 1.4-percentage-point rise in 10-year Treasury yields this year pushed interest rates on 30-year fixed mortgages to above 5 percent for the first time since before Bernanke announced on March 18 that the central bank would start printing money to buy financial assets. Treasuries have lost 5.1 percent in their worst annual start since Merrill Lynch & Co. began its Treasury Master Index in 1977.

“The bond-market vigilantes are up in arms over the outlook for the federal deficit,” said Edward Yardeni, who coined the term in 1984 to describe investors who protest monetary or fiscal policies they consider inflationary by selling bonds. He now heads Yardeni Research Inc. in Great Neck, New York. “Ten trillion dollars over the next 10 years is just an indication that Washington is really out of control and that there is no fiscal discipline whatsoever.”

Investor Dread

What bond investors dread is accelerating inflation after the government and Fed agreed to lend, spend or commit $12.8 trillion to thaw frozen credit markets and snap the longest U.S. economic slump since the 1930s. The central bank also pledged to buy as much as $300 billion of Treasuries and $1.25 trillion of bonds backed by home loans.

For the moment, at least, inflation isn’t a cause for concern. During the past 12 months, consumer prices fell 0.7 percent, the biggest decline since 1955. Excluding food and energy, prices climbed 1.9 percent from April 2008, according to the Labor Department.

Bill Gross, the co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co. and manager of the world’s largest bond fund, said all the cash flooding into the economy means inflation may accelerate to 3 percent to 4 percent in three years. The Fed’s preferred range is 1.7 percent to 2 percent.

“There’s becoming an embedded inflationary premium in the bond market that wasn’t there six months ago,” Gross said yesterday in an interview at a conference in Chicago.

Shrinking Economy

Bonds usually rally when the economy is in recession and inflation is subdued. Gross domestic product dropped at a 5.7 percent annual pace in the first quarter, after contracting at a 6.3 percent rate in the last three months of 2008, according to the Commerce Department.

This time it’s different because the Congressional Budget Office projects Obama’s spending plan will expand the deficit this year to about four times the previous record, and cause a $1.38 trillion shortfall in fiscal 2010. The U.S. will need to raise $3.25 trillion this year to finance its objectives, up from less than $1 trillion in 2008, according to Goldman Sachs Group Inc., one of 16 primary dealers of U.S. government securities that are obligated to bid at Treasury auctions.

“The deficit and funding the deficit has become front and center,” said Jim Bianco, president of Bianco Research LLC in Chicago. “The Fed is going to have to walk a fine line here and has to continue with a policy of printing money to buy Treasuries while at the same time convince the market that this isn’t going to end in tears with fits of inflation.”

‘Potential Benefits’

Ten-year note yields, which help determine rates on everything from mortgages to corporate bonds, rose as much as 1.71 percentage points from a record low of 2.035 percent on Dec. 18. That was two days after the Fed said it was “evaluating the potential benefits of purchasing longer-term Treasury securities” as a way to keep consumer borrowing costs from rising.

The yield on the 10-year note rose one basis point, or 0.01 percentage point, to 3.47 percent this week, according to BGCantor Market Data. The price of the 3.125 percent security maturing in May 2019 fell 3/32, or 94 cents per $1,000 face amount, to 97 4/32. The yield touched 3.748 percent yesterday, the highest since November.

The dollar has also begun to weaken against the majority of the world’s most actively traded currencies on concern about the value of U.S. assets. The dollar touched $1.4169 per euro today, the weakest level this year.

Bond Intimidation

Ten-year yields climbed from 5.2 percent in October 1993, about a year after Clinton was elected, to just over 8 percent in November 1994. Clinton then adopted policies to reduce the deficit, resulting in sustained economic growth that generated surpluses from his last four budgets and helped push the 10-year yield down to about 4 percent by November 1998.

Clinton political adviser James Carville said at the time that “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.”

The surpluses of the Clinton administration turned into record deficits as George W. Bush ramped up spending, including financing of the wars in Iraq and Afghanistan.

The bond vigilantes are being led by international investors, who own about 51 percent of the $6.36 trillion in marketable Treasuries outstanding, up from 35 percent in 2000, according to data compiled by the Treasury.

New Group

“The vigilante group is different this time around,” said Mark MacQueen, a partner and money manager at Austin, Texas- based Sage Advisory Services Ltd., which oversees $7.5 billion. “It’s major foreign creditors. This whole idea that we need to spend our way out of our problems is being questioned.”

MacQueen, who started in the bond business in 1981 at Merrill Lynch, has been selling Treasuries and moving into corporate and inflation-protected debt for the last few months.

Chinese Premier Wen Jiabao said in March that China was “worried” about its $767.9 billion investment and was looking for government assurances that the value of its holdings would be protected.

The nation bought $5.6 billion in bills and sold $964 million in U.S. notes and bonds in February, according to Treasury data released April 15. It was the first time since November that China purchased more securities due in a year or less than longer-maturity debt.

Obama’s Confidence

Treasury Secretary Timothy Geithner, who will travel to Beijing next week, will encourage China to boost domestic demand and maintain flexible markets, a Treasury spokesman said yesterday.

Obama spokesman Robert Gibbs said the president is confident that his budget and economic plans will cut the deficit and bring down the nation’s debt.

“The president feels very comfortable with the steps that the administration is taking to get our fiscal house in order and understands how important it is for our long-term growth,” Gibbs said.

Investors are also selling Treasuries as the economy shows signs of bottoming and credit and stock markets rebound, lessening the need for the relative safety of government debt. And while yields are rising, they are still below the average of 6.49 percent over the past 25 years.

‘Renewed Appreciation’

The world’s largest economy will begin to expand next quarter, according to 74 percent of economists in a National Association for Business Economics survey released this week. The Standard & Poor’s 500 has risen 36 percent since bottoming on March 9, while the London interbank offered rate, or Libor, that banks say they charge each other for three-month loans, fell to 0.66 percent today from 4.819 percent in October, according to the British Bankers’ Association.

Three-month Treasury bill rates have climbed to 0.13 percent after falling to minus 0.04 percent Dec. 4. That flight to safety helped U.S. debt rally 14 percent in 2008, the best year since gaining 18.5 percent in 1995, Merrill indexes show.

“Yes there’s been a big move, and you can argue the big move is driven by the renewed appreciation of the risks associated with holding long-term Treasury bonds,” said Brad Setser, a fellow for geoeconomics at the Council on Foreign Relations in New York.

Fed officials see several possible explanations for the rise in yields beyond investor concern about inflation. Among them: The supply of Treasuries for sale exceeds the Fed’s $300 billion purchase program, the economic outlook is improving and investors are selling government debt used as a hedge against mortgage securities.

Liquidity

Central bankers want to avoid appearing to react solely to market swings. Bernanke hasn’t formally asked policy makers to consider whether to increase Treasury purchases and may not do so before the Federal Open Market Committee’s next scheduled meeting June 23-24. Officials are confident they can mop up liquidity without gaining additional tools from Congress, such as the ability for the Fed to issue its own debt.

The Fed declined to comment for the story. Bernanke has an opportunity to discuss his views when he testifies June 3 before the House Budget Committee in Washington.

“We have daily reminders from bond vigilantes like Bill Gross about the prospect of losing our AAA rating,” Federal Reserve Bank of Dallas President Richard Fisher said in Washington yesterday. “This cannot be allowed to happen.”

Repair the Damage

The government and Fed are trying to repair the damage from the collapse of the subprime mortgage market in 2007, which caused credit markets to freeze, led to the collapse of Lehman Brothers Holdings Inc. in September and was responsible for $1.47 trillion of writedowns and losses at the world’s largest financial institutions, according to data compiled by Bloomberg.

The initial progress Bernanke made toward reducing the relative cost of credit is in jeopardy of being unwound by the work of the bond vigilantes.

The average rate on a typical 30-year fixed mortgage rose to 5.08 percent this week from 4.85 percent in April, according to North Palm Beach, Florida-based Bankrate.com. Credit card rates average 10.5 percentage points more than 1-month Libor, up from 7.19 percentage points in October.

“Longer term the danger is that the rise in yields disrupts the recovery or the rise in inflation expectations dislodges the Fed’s current complacency on inflation,” Credit Suisse Group AG interest-rate strategists Dominic Konstam, Carl Lantz and Michael Chang wrote in a May 22 report.

‘It’s Over’

Inflation expectations may best be reflected in the yield curve, or the difference between short- and long-term Treasury rates. The gap widened this week to 2.76 percentage points, surpassing the previous record of 2.74 percentage points set on Aug. 13, 2003. Investors typically demand higher yields on longer-maturity debt when inflation, which erodes the value of fixed-income payments, accelerates.

“The yield spreads opening up imply that inflation premiums are rising,” said former Fed Chairman Alan Greenspan in a telephone interview from Washington on May 22. “If we try to do too much, too soon, we will end up with higher real long- term interest rates which will thwart the economic recovery.”

Other economists are more pointed. After falling from 16 percent in the early 1980s, 10-year yields have nowhere to go but up, according to Richard Hoey, the New York-based chief economist at Bank of New York Mellon Corp.

“The secular bull market in Treasury bonds is over,” Hoey said in a Bloomberg Television interview. “It ran a good 28 years. They’re never going lower. That’s it. It’s over.”

Mortgage Rates Soar

from Bloomberg:
Yields on Fannie Mae and Freddie Mac mortgage bonds rose for a fourth day, after yesterday for the first time exceeding where they stood before the Federal Reserve announced it would expand purchases to drive down loan rates.

Yields on Washington-based Fannie Mae’s current-coupon 30- year fixed-rate mortgage bonds climbed to 4.3 percent as of 10:25 a.m. in New York, the highest since March 10 and up from 3.94 percent on May 20, data compiled by Bloomberg show.

The Fed, seeking to use lower home-loans rates to stem the housing slump and bolster consumers, said March 18 it would increase its planned purchases of so-called agency mortgage bonds by $750 billion, to as much as $1.25 trillion, and start buying government notes. Rising mortgage-bond yields, driven higher in part by climbing Treasury rates, means the Fed now “faces a challenge to its ability to sustain low mortgage rates,” according to Jeffrey Rosenberg at Bank of America Corp.

“Market participants may be asking themselves the same question as Scorpio in ‘Dirty Harry’: ‘Do I feel lucky?’ ” Rosenberg, the bank’s head of credit strategy research in New York, wrote in a report yesterday, referring to a character in the 1971 Clint Eastwood film who may be shot.

Bond Vigilantes Beating Fed At Its Own Game

Apparently, market forces are beating the Fed in its attempts to artificially force interest rates lower. This daily chart shows the long, green spike in treasuries (30 yr) that occurred six weeks ago when the Fed announced it would buy long-term treasuries. That was the lower interest rates ever were. They have been rising steadily since, especially accelerating downward (higher interest rates) in recent days, despite that the stock market has been largely flat for a month!

Fed Fights Back Against Bond Vigilantes

I haven't seen the data, but in an environment in while investors have been selling U.S. treasuries, it appears that the Fed's verbal intervention last Tuesday may be having an impact. Interest rates overnight have been moving lower, even on long-term treasury futures, including both the 10-year and 30-year. The charts show increasing treasury purchases and higher prices, despite a "debacle" in treasury purchases according to a fellow blogger who is a bond specialist. He suggested that last week's treasury auctions were a debacle because of weak demand. How, then, are they so strongly higher overnight?

The Bond Vigilantes are Back

From Barrons today, suggesting that interest rates are starting to rise. The article indicates that nations' debt ratings are increasingly threatened by unbridled borrowing:

The incoming Obama administration got a rude reception from the debt markets.

Ed Yardeni, who coined the term "bond vigilantes" back in the early 'Eighties, sees them being roused again. Then, the vigilantes' main target was inflation; now it's burgeoning budget deficits around the globe.

The eponymous head of Yardeni Research notes that the Congressional Budget Office is projecting a fiscal 2009 budget deficit of $1.2 trillion -- 8% of U.S. gross domestic product. And that's before President Obama's $800 billion stimulus plan.

Reading the entire news story requires a paid subscription to Barrons. This story seems to confirm my post from Thursday incidating that long-term interest rates -- which are less subject to Fed manipulation -- are rising, like it or not.

Bond Vigilantes Take the Bull By the Horns

Wow! The bond vigilantes have taken the treasury bull by the horns, and are selling treasuries in force today. Apparently, the treasury market is expecting the Fed to cease easing interest rates soon, but they are driving interest rates higher by selling treasuries. Treasuries reached their high on March 17th, and have been trending lower ever since, forcing interest rates higher despite Fed easing. This 15 minute chart today shows the selling activity, with the commensurate interest rate rise. The US Dollar is also modestly higher overnight.

In some ways, this is a good sign, because equity markets have fully priced in a recession, and equities prices have been slowly edging higher as well. Funds are moving out of safe-have treasury investments and back into stocks, albeit on somewhat weak volume. Even bad news for the U.S. economy (investment bank refunding, poor jobs report) over the past week has caused stocks to rally. This is a good example of a case in which the market moves contrary to what would have been expected. It is also an example of the leading nature of stocks and the almost nutty, optimistic nature of equity markets to hope for -- even expect -- improvement soon.

Gold Falls, Then Rebounds

Gold has shown remarkable resilience, and after falling initially (see the chart), prices have rebounded higher to about where they ended last week. This may indicate price strength, especially in light of lower interest rates, higher inflation, and US Dollar weakness. It is also possible that some of the funds flowing out of bonds (see my earlier post today), are flowing into gold for greater safety and protection of value.

In this earlier post, this connection between bond selling and gold buying is explained further:

Bond Vigilantes - Where Are They?