By Terry Connelly
For the past several months, the so-called “bond vigilantes” of Wall Street have been enjoying their moment with the relish of starved beats crashing a picnic.
During the six years since the onset of the Great Financial Crisis, the bond traders have had little to do but “endure” high bond as Federal Reserve held short interest rates down to near freezing level and layered on, off and on again QE I, II and III as the buyer of first resort of longer-term government and mortgage debt – keeping supply constrained, prices up and interest rates down to spur an economic recovery – but not the rate of volatility that is mother's milk to the traders.
They made money, but not a usual “killing” particularly in terms of “total return” including interest rate yield, which has been stranded at an unprecedented (and? unpredicted) historic low. They blamed their underperformance on the Fed policy of market interference and resulting artificial pricing that they detest ideologically. So what if it helped end the Great Recession; they viewed the Fed moves as the “Great Theft” of the bond investors’ due.
All about QE III
Their opening came in May when Fed Chairman Ben Bernanke somewhat casually let it slip in his semi-annual Congressional testimony that the Fed might begin to dial back its $85 billion per month QE III bond purchases “later this year” if the economy continued to improve as forecast. They chose to take Bernanke at half his word and dumped bonds like hot potatoes -- choosing to interpret Bernanke’s conditional probability of tapering as a virtual promise – and having made that bet, they are determined to hold him to it by (market) force! That’s what vigilantes do, after all.
Ever since, whenever there has been any good news about the economy, the traders have dumped bonds, driving their prices further down and their yield (the skyward?), at least in relative terms. Today’s 2.85% interest rate on the ten-year Treasury bond – the benchmark for mortgage pricing – is hardly a scary all-time high; it’s well below the historical average of about 2% above the inflation rate, which just now is hovering around 1.7%. But 2.85% is 125 basis points higher than 1.6% as short a time ago as April. Thus the yield on the ten-year has spiked 75% in less than half a year – a self-administered shock to the bond market forced by traders who think themselves very clever fellows and ladies.
Fight the Fed
Not for them the old house rule – “don’t fight the Fed.” They’re not only fighting the Fed, they’re baiting the Fed to follow through on its tapering talk and spike interest rates even further.
Why are the bond vigilantes purposely driving down the market value of their stock-in-trade, anyway? Part of the reason is ideological. They hate Bernanke as an interloper, and Obama for the same reason, so they are reluctant to believe that the economy is actually recovering under the leadership of those two faculty-lounge geeks.
The vigilantes are like the hedge fund guys who share the same ideological hates and have been (wrongly) shorting the stock market for several years. Now both the bond vigilantes and the hedgies see a chance to “get theirs” back -- notice how the friends of hedge funds have quickly used the bond rate spikes to renew their cable TV calls for a deep stock price “correction” that will bail out the hedge funds and give them a chance to get back into the market on the cheap.
The bond traders may be playing the same game. Their relentless dumping of bonds seems to make no sense on the surface. If they indeed think the Fed is bound to be wrong about the economy’s recovery -- and if they succeed in bullying the Fed into wrongly starting its tapering too early, it would follow that whatever recovery is going on will stop cold and trigger talk of a double dip recession. In that event, government bonds should rally hard in price, especially if the Fed reverses course and quickly renews its bond purchases. Why would the traders want to miss that pick up in the value of bond holdings? Well, maybe they won’t.
Driving the market
Perhaps the vigilantes are purposely driving down bond prices so they can soon enough (say, late September) pick them up again on the cheap and enjoy the snap back? Do you think that tactic has ever happened on Wall Street before? Maybe they also realize September brings debt ceiling/government shutdown crisis season, which could also trigger a “flight to safety” into government bonds if history is any guide – despite the idiotic potential for a bond default.
Or are the traders also trying to force the Fed not only to taper but also to advance the date that they increase short rates. The Fed is committed to keeping them at near zero at least until unemployment falls below 6.5% -- a long way off if you believe the economy is really in bad shape as far off as 2016. Too long a wait if you have already made a futures market betting on the Fed being forced by the market “pull” of much higher ten-year rates to follow suit with short rates by as early as January 2015.
Bottom line: the bond traders are trying to wrest control of bond rates from the Fed. No way the Fed wants a ten-year approaching 3% now or any time soon, because of its deleterious effects on mortgage rates and thus the housing recovery that is providing sustenance to the slow but steady recovery. Here’s where Bernanke’s instincts for how to treat a bully may emerge. The Fed can simply delay its tapering beyond September and confound the vigilantes bet for many reasons –- insufficient data on incoming Q3 GDP for one. But Bernanke’s main reason not to taper just now might be the “unwarranted” (as he has already labeled it) sharp increase in the ten-year Treasury bond rate the vigilantes have themselves engineered!
To beat a bully – punch him in the nose. The bond equivalent would be catching a trader short and wrong. Ouch!
Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.