Bond vigilantes for Dummies
A few weeks ago, the Labour back-bencher, Paula Baker, was held to have disgraced herself with remarks revealing that she hadn’t much of a clue about the bond market. There have been similar such remarks from Zarah Sultana and Nadia Whittome, other Labour back-benchers. Cue for much chuntering by those claiming to know better. But this is silly. Why should Labour back-benchers turn up knowing all about the bond market ? They have recently been hired to a new job with new responsibilities. Like the rest of us, they have to learn on the job.
Come to think of it, why should you, the reader of this blog, know such things? You’re all about politicians, polls and programmes. Even the freest market of inclinations are no education in the gobbledegook of bonds, with its weird vocabulary and unintuitive arithmetic. So, here’s the “for Dummies” story.
First the borrowers: Governments almost always need money to cover the gap between spending and taxing. So they borrow it. For millennia, kings dunned rich subjects; after 1450 or so they or their successors went to banks. Since the 1750s, however, first Britain and then others have bypassed banks by going direct to lenders with series of identical pre-packaged contracts, to borrow a fixed sum and pay it back at a fixed time, in return for a fixed sum of interest. These contracts are called “bonds”. Their secret sauce is that lenders are dead keen, as they aren’t stuck with the bonds permanently: they can buy and sell them in the “secondary market”.
In the jargon, borrowers “issue bonds”, which lenders “buy”, or in which they ”invest” (same thing). Governments issue bonds at “auctions”, which fix the interest. A bit more jargon: the US issues “Treasuries” (after the name of the issuing department); the UK, “Gilts” (after “gilt-edged securities”, harking back to a happier time when HMG was the best imaginable borrower); and the Germans, “Bunds” (not a weird German form of “bond”, but after the formal name of the country, the Bundesrepublik, the Federal Republic, and its bank, the Bundesbank). Collectively, government bonds are known as “Sovereigns”, to distinguish them from those issued by the private sector, “Corporates”.
Now the lenders (remember, also “investors” or “buyers”). They are largely you and me, through our pensions, insurance policies or other savings. These are assembled into funds, much of which is invested in bonds. The main other investors are foreign governments, to which we’ll come in a minute.
What do investors or buyers want? Simples. They want to get their interest and their original money back. So, they look at what every lender always looks at: the inclination and the capacity of the borrower, failing which, what’s the collateral? Inclination is taken from the record: is the government borrower a duffer: has it failed to pay? That rarely happens with Sovereigns, but there’s a tougher follow-on: have borrowers repaid in currency less valuable than the original debt; in other words, are they given to inflation?
The answer is always yes, with some worse than others. Germany suffered hyperinflation in 1923; since then, it has been tougher on inflation than elsewhere. Since the establishment of the Deutsche Mark in 1948, its cumulative inflation has been c460%. That sounds like a lot, but Britain’s record is ten times higher at 4620%. The US is in the middle, at 1285%. These disparities, which have prevailed for an adult lifetime, are now altering, but not in a good way: Germany and the US are deteriorating, while we are getting no better.
Government borrowers disdain to offer collateral, as they rely on the taxing power, its capacity deriving ultimately from GDP and the prospects for growth. Somewhere between inclination and capacity is the current economic and political set-up: what other financial obligations? what popular mood? what parliamentary (or equivalent) configuration? what growth in prospect? Interest levels are a haggle between borrowers and lenders, based on a judgement of the answers to these questions.
A final wrinkle on the buyers: foreign governments want to hold dollars as a safe haven, for currency manipulation, or for paying for foreign trade, much of which is denominated in dollars. But they can get out in a hurry.
Let’s tackle the unintuitive arithmetic. Bonds are issued with a pre-determined rate of interest or “coupon”. If their value goes down in the secondary market, the arithmetic means that the return for a bondholder, the “yield”, goes up. So higher yields are a bad thing: they mean lower bond prices which raise the cost of new public borrowing. So too a “yield spike” which means things have just gone wrong, or a “yield premium”, which means they have been wrong for a while. If you hear of investors “demanding higher yields”, it sounds like they are failing to turn up for new bonds, but more generally it means that they are dumping bonds in the secondary market, pushing prices down.
As to the current story, western governments have been in trouble since 2008, all the more so since Covid. Much attention has gone to “the US deficit reaching $40tn”, but this is a bit dopey - akin to a “big number” birthday. The real point is comparing it with the capacity to pay back, for which as noted above, the proxy is the relationship to GDP.
Bond buyers know Trump’s record. In his property business, he treated creditors as mugs to be squeezed, not debts to be honoured. No-one forgets. His tax cuts would push US borrowing towards post-war extremes, with Federal debt already 101% of GDP. The Americans still have the dollar, but yields are the highest since 2007
Other debt levels are already dangerous. Japan is the outlier above 250% of GDP, but its debt is mostly domestically owned. French debt levels and yields are similar to the US, but with lower growth and conspicuously little appetite for austerity. The German deficit remains below 70%, but yields are now the highest since 2011. Britain has poor growth, public dysfunction, a bad long-term record and no reserve currency shield, with yields the highest since 1998.
Everyone is competing for cash. The US is borrowing nearly $2 trillion a year. This is not an absolute record, but it is the highest ever for a period of economic expansion, with uncontrolled expenditures on debt and social security. Underlying strains include ageing, defence, energy, and AI.
Indeed, AI has already become a credit story. The big private sector promoters are spending $1tn this year, state-sized sums, with AI infrastructure bonds already above $100bn a year. The collateral is inflated equity, overpriced chips, unbuilt data centres and hope. Not everyone can win and regulation is coming. If the AI model breaks, equity falls first, with debt next.
US Treasury Secretary Bessent has not calmed markets. His 19 August buybacks bought a few hours’ relief, then yields rose again. The reasons are simple: a few billion of purchases cannot fix a $40tn debt load, a $1.9tn deficit, debt heading from 101% to 120% of GDP by 2036, heavy AI borrowing, or fears that Trump will drag the Fed into financing the state.
Now for them bond vigilantes. They don’t wear badges - no sombreros or bandanas. They are often recruited from that most obscure of disciplines, actuaries. But every once in a while, the fund-managers whom governments take for granted can change their mood. In the nature of things, bond buyers hate high debt, poor growth, unstable politics and the lack of credible plans to make things right. But they can sit on their hands for a surprising amount of time. Then the tone shifts. Often it’s this time of year, after they have had August to think things over. It can be slow, through a steady grind, or sudden, if an auction fails or a Budget looks unserious.
If vigilantes go after the US, the Fed can buy more bonds for a few days. But keeping this up risks inflation and a Trump-Fed fight. That threatens a cost-of-living issue before the mid-terms, the sort of uncertainty the markets hate.
And back in dear old Blighty, we have a target on our back. Although our net debt is not the worst, at some 95% of GDP, we have a terrible record: remember those inflation figures. We also have the mix most toxic to markets: not merely the highish debt, but a litany of chaotic politics, dysfunction in public services and regulation, high energy costs, new defence demands, no growth story, and uncontrolled spend on interest and welfare. Sterling is not the dollar. Britain is not Japan, with its domestic savings base. Nor is it Germany, with a reputation for discipline. Once gilt investors decide Britain’s drift is once again moving from chronic to acute, borrowing costs will rise further. If that happens, the choices will narrow fast: higher taxes, lower spending, or both. The bond market will turn an abstract problem into a squeeze on the government and us.
October is the cruellest month.
Miles Saltiel