Bond Vigilante or ‘Very Antsy’? - Global market update

Given the time of year, with secondary school pupils the length and breadth of the country in the final throes of study before sitting the junior (I still think of it as the ‘inter’!) and leaving certificate exams, it seems apt to draw on some Shakespeare to kick off this week’s missive. Now, I know there will be many out there that will, at the mention of the great bard, be gripped bypanic and anxiety, but bear with me for a few minutes. One of the most quoted – but often mistakenly attributed to the lead character – lines from the play Hamlet is uttered by Marcellus, a palace guard, when he says that “something is rotten in the state of Denmark”. Any investors looking at the government debt markets of the major economies in the last few weeks might, understandably, conclude that ‘some troubling is happening in the state of bond land’ – a situation that some have described as a ‘slow motion car crash’!

Yields at the so-called ‘long end of the curve’ have been moving steadily higher over the last month in countries like the US, Japan, the UK and France. While a simultaneous move in interest rates is not out of the ordinary, it is the size of the move (to levels not seen in many years and, in some cases, decades) as well as the fact that the countries have different political systems, different central banks and different future paths for official interest rates that are causing investors to sit up and pay attention.

With such a uniform move higher in yields for these countries, and notwithstanding the differences outlined above, it seems reasonable to conclude that some other underlying factor must be at play. And while others may dispute the fact, the reality is that the bond market vigilantes (BMVs) are making their voices heard when they say that there is too much debt, too little fiscal discipline by governments and, most importantly, little to no evidence that the political appetite exists to deal with either of these problems.

It is fair to ask what has happened to raise the ire of the BMVs to cause them to be so recalcitrant? The obvious trigger has been the Iran war and the resulting shock to oil supply. The ongoing failure to come up with a political or military resolution to the blockades of the Strait of Hormuz has steadily raised inflationary pressure. The most drastic impacts have naturally been felt in countries that rely on imports for energy. For example, long-term inflation expectations in Japan and Germany – two countries that most believed had sounded the death knell for inflation pressures – have surged over recent weeks.

Against this backdrop, if there was one new job that you certainly wouldn’t want to be taking up soon, it would be the head of a central bank, and particularly the chair of the US Federal Reserve (Fed). If Kevin Warsh was looking for an easygig, he chose the wrong employment opportunity. Beyond the obvious pressure of having the US President second-guess your every move (or non-move, as the case may be), there’s the legitimate challenge of how to navigate the policy backdrop in a frenetic atmosphere of inflation worries, fiscal deficits and rising global yields. He has long been on record saying that he wants to trim the Fed balance sheet (reduce money supply) and cut interest rates (keep the President happy), which is all well and good when you’re hurling peanuts from the cheap seats but may prove rather more difficult once you’re in the hot seat.

Throw into the mix the historical tendency of the market to “test” new Fed chairs, as they ‘haze’ the newbie in a fashion like college fraternity pledges or military recruits, to assess their worth and encourage bonding – there’s an initial period of unpleasantness, and then the new member is welcomed into the fold. The market seems to be assigning him “raise interest rates” as one of his pledge tasks.

And why is this important? Well, bond markets set the price of money, and they have provided a prop for equity market valuations for two decades – so this cannot be ignored. Yet, equities seem so calm about this with earnings forecasts surging and the growth of artificial intelligence (AI) spending a major counterweight to the hit from the Iranian conflict.

Stocks offer an inflation hedge, which bonds certainly don’t, and they have a growth story, which may explain some of the divergence in opinions. But if yields continue to move higher, then just like Shylock in the Merchant of Venice, the bond vigilantes will be looking for the ‘pound of flesh’ from “Signior Antonio Equity”.