Bond market vigilantes saddle up

By J Saft
April 10, 2009

jimsaftcolumn– James Saft is a Reuters columnist. The opinions expressed are his own –

Efforts to reflate the economies of the U.S. and Britain are running into one potentially major problem; the bond market.

Appetite for government debt in recent sales has been very poor, raising the cost to the two governments of borrowing and blunting their efforts to bring down market interest rates by buying back their debt.

This is a big risk for British and U.S. efforts to rescue their economies, and could be yet another self reinforcing downward force if holders of government debt get the frights.

Both countries are running hugely expansionary fiscal stimulus programs that will need to be paid for by gargantuan sales of government debt. At the same time both have such low official interest rates, 0 to 25 basis points for the U.S. and

50 basis points in Britain, that they are engaging in purchases of their own debt, or quantitative easing, in the hope that this lowers rates for consumers and businesses and encourages money to be spent or invested.

It is impossible to know exactly how effective the policy is, after all we don’t know what rates would be without it. We can though see two things clearly; there are lots of sellers when the U.S. and Britain seek to buy their own bonds, but when it comes to the far larger operation of issuing bonds to fund ongoing needs, investors are markedly less enthusiastic. The U.S. Treasury got a very poor response on Tuesday when it auctioned $6 billion of 9-year, 9-month inflation-indexed notes at a yield of 1.589 percent, better terms for investors than similar issues on the secondary market at the time. Of particular note was the fact that so-called indirect bidders, mostly foreign central banks, stepped up for just 26.1 percent of the sale, as against 47.2 percent at the last such auction in January, which was before the policy of Fed purchases of Treasuries was announced.

Mohammed El-Erian of leading bond investor PIMCO told CNBC that government bonds were “not worth owning right now” because of the “tremendous” amount of debt the U.S. will have to sell.

The Fed will buy up to $300 billion worth of longer-dated Treasuries over the coming months to help keep interest rates low throughout the economy but at the same time it is buying from a market that is well aware that the Treasury needs to sell some $2 trillion of debt this year.

Speaking in Tokyo, it was clear that Dallas Fed governor Richard Fisher is aware of foreign investor’s concerns and has been seeking to reassure:

“Demand for U.S. Treasuries … will be determined by their attractiveness relative to alternatives and they may be judged more, rather than less, attractive under most reasonable future scenarios,” he said on Wednesday.

The Fed is determined to “short-circuit” any inflationary consequence of its balance sheet growth, and is in the process of acquiring new tools to help, he said.

“We realize … we are at risk of being perceived as monetizing the fiscal largess of Congress,” Fisher said.

Exactly. And while some might argue that the higher interest rates the U.S. may be paying will inflate away unpayable debts, this is perception that if anchored among investors, can very easily take on an extremely dangerous momentum of its own.


Similarly, the Bank of England intends to buy up to 75 billion pounds of assets, mostly gilts, over three months, but similarly Britain plans to issue a record 147 billion pounds of gilts in the coming financial year. There is also the possibility of more issuance to come if an upcoming budget includes new provisions for simulative spending.

Britain was unable to sell more than 100 million pounds of 40 year gilts at the end of March, the first such failure since 1995, and had to make heavy concession at an auction earlier this week.

All in all, it’s a sort of strange mirror to the criticism that is made of temporary stimulus measures; that because taxpayers can tell they will be forced to pay in future for the goodies they are given now they may save, blunting the impact of the stimulus. In the same way, today’s bond buy backs will need to be financed via tomorrow’s taxes, bond issues or eroded via inflation, making the current path of policy a very difficult tightrope.

It may be that in a world of poor alternative investments both countries can sell their debts at reasonable prices, but along with and interacting with currency moves, it is an important vulnerability.

The bond market vigilantes, who used to enforce a rough and sometimes destructive justice, may be saddling up again.


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