BOND VIGILANTES WANTED: MOHINDRA,
Will the dark knights of the bond market rise again? The term “bond vigilantes” was invented over 30 years ago by economist Ed Yardeni to describe bond traders that would react to inflation or credit risk by demanding higher yields through shorting government bonds. The vigilantes became such a formidable force at imposing discipline on governments and central banks that a Bill Clinton administration adviser once remarked his preference to be reincarnated as the bond market rather than the president, the pope or a .400 baseball hitter on the basis that the bond market can intimidate everybody.
But central banks have now successfully beat back the bond vigilantes. The vigilantes were in full gear during the eurozone crisis that emerged in 2009 following an acknowledgement by Greece that it had been underreporting its deficits. Several eurozone members ultimately cut back spending. However, central banks have now effectively neutralized the vigilantes by engaging in quantitative easing.
If a vigilante sells a bond, the central bank will create money to buy it, thus eliminating any impact on prices or yield.
The lack of market discipline from the disappearance of bond vigilantes has resulted in central banks and governments becoming increasingly emboldened. Governments are again moving towards more fiscal stimulus on the basis that monetary stimulus is not enough. The U.K. chancellor who ran large government deficits during his entire tenure was dismissed for his reputation for austerity. An ominous new trend that is emerging is weaker market governance of the corporate sector as central banks acquire corporate securities.
The Bank of England has now joined the European Central Bank in purchasing investment grade bonds from nonfinancial corporations. The Bank of Japan, which has been acquiring corporate securities through exchange- traded fund and real estate trust purchases has also expanded its program to almost double the original amount.
The Bank of England’s rationale is that purchases of corporate bonds could provide more stimulus than sovereign bond purchases because, as corporate bonds are higher- yielding instruments, i nvestors selling corporate debt to the Bank of England could be more likely to invest the money received in other corporate assets. In addition, Bank of England purchases could stimulate issuance in sterling corporate bond markets. The use of the word “could” in the bank’s statements does not project much con- fidence in this strategy. And why the bank wishes to promote leverage relative to other forms of capital is simply mystifying.
The moves by the central banks will reduce the incentives of corporate managers to perform as they find themselves with a new supplier of capital that has objectives other than maximizing returns. For instance, U. K. corporate managers will be incented to prioritize maximizing “material contributions to the U. K. economy” over maximizing shareholder returns in order to meet the Bank of England’s criteria for being in their winner’s circle. The distortion of management incentives will ultimately run counter to the sustainable global economic growth the G20 has indicated it is pledged to.
In addition, young innovative firms lacking either investment grade credit ratings or ( in Japan’s case) a presence in major stock market indexes will experience an increase in the spread between their costs of capital and that of large corporations. The forays of central banks into corporate securities to date may be small and measured. But the trend will likely continue as long as economic growth remains elusive, and central banks find fewer and fewer government bonds available for purchase.
When the dark knights of the bond market will rise again is unclear. Markets remain stacked against them as long as central banks continue to maintain quantitative easing in their tool kit. One possible scenario is if Portugal loses its last remaining investment grade rating, rendering it ineligible for the European Central Bank’s bond- buying program.
But until the vigilantes do return, central banks and governments will continue to push boundaries, and the need for the vigilantes’ return to impose market discipline will keep growing.
THE LACK OF MARKET DISCIPLINE HAS RESULTED IN CENTRAL BANKS BECOMING INCREASINGLY EMBOLDENED.