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."
