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Most-feared traders threaten Treasuries once again
E CRAIG Coats Jr never set out to be a bond vigilante. As the former head of Salomon Brothers' Treasuries desk, the last thing on his mind running the world's biggest debt trader in the 1970s and 80s was fighting Washington's fiscal largesse. He had a much simpler agenda: survive.
In an era when inflation outbreaks could send yields surging hundreds of basis points in a matter of days, getting stuck on the wrong side of the bond market could end your career. That's why for Mr Coats, any hint consumer prices were poised to spike was a sign to sell with both hands. The knock-on effect, of course, was that he inadvertently became a disciplinarian of American budgetary freewheeling, forcing officials to curb inflationary policies or risk an upward spiral in funding costs.
It's been a generation since traders like him last imposed their will on Washington and Wall Street alike. Yet the original vigilante says he's seeing signs that the once feared punishers of profligate spending are lurking again, lured back by an expansionary fiscal policy and signs of resurgent inflation - just as the world's central banks dial back years of unprecedented bond buying that's largely shielded politicians from market pressures.
"Some of the stirrings from what we used to know about the old days of inflation are really starting to rear their head," Mr Coats, now retired, said from Florida. Back then "people paid a lot more attention to the deficits and the cost from the standpoint of what it was to the Treasury. Not so much now, but I think those days are going to be coming back."
No one is predicting a return to the bond markets of yesteryear, in which the guardians against government excess could stymie political agendas and dictate the course of policy. Central banks remain a domineering force, even if their sway is set to erode. Foreign demand for US debt remains robust. And a brewing trade war between America and its allies is stoking demand for haven assets once again. Yet signs the vigilantes are re-emerging can be seen across the US$14.7 trillion Treasuries market.
Congress's bipartisan vote last month to increase spending by nearly US$300 billion over the next two years comes on the heels of the US$1.5 trillion, 10-year tax cut President Donald Trump signed into law in December. Wall Street strategists have slated over US$1 trillion in new debt issuance this year alone to fund them.
That's only expected to grow as an ageing population further fuels entitlement outlays while rising interest rates buoy Washington's debt-servicing costs. The White House's 2019 budget proposal released last month would raise the deficit to US$984 billion, nearly double projections from last year. The red ink would total US$7.1 trillion over the next decade, pushing the national debt to nearly US$30 trillion.
Deficit and debt
"This is a big problem, not just short term deficits but the debt," said Liz Ann Sonders, chief investment strategist for Charles Schwab & Co. "We are playing with a lot of large numbers now. It changes the supply-demand dynamic in the Treasury market."
To keep pace with this rising shortfall, net Treasury issuance to the public will average US$1.27 trillion per year over the next five years, according to strategists at BMO Capital Markets. That compares to an average of US$658 billion over the past five years. On Monday, investors digested a whopping US$145 billion of fresh supply, including an unusual double sale of 3- and 10-year maturities, demanding the highest yields in years on the notes to absorb the larger auction sizes.
The fiscal stimulus comes as data on employment, wages and consumer prices have all exceeded analyst estimates in recent months, only further stoking inflation concerns.
"We've had the tax cuts, fiscal stimulus and strong growth combined with all-time high levels of optimism in surveys - and people are putting it all in their Phillips curve models and saying 'Oh God, we are going to have inflation," said Jim Bianco, president of Chicago-based Bianco Research, referring to theory that falling unemployment is met with faster inflation.
The 10-year break-even rate, calculated from the difference between yields for nominal and inflation-linked bonds, reached 2.15 per cent last month, the highest since 2014. Traders already wagering the Federal Reserve will increase rates three times this year are beginning to position for the possibility of a fourth. And of course, two-year yields have breached 2 per cent for the first time since 2008, while 10-year yields are on the cusp of 3 per cent for the first time in four years.
Analysts, in turn, are reexamining their 2018 yield forecasts. "Stimulative but unpaid- for tax cuts in the late stages of the business cycle have pushed up bond yields to the point where it has already started to cause stress," said Jeff Caughron, chief operating officer at Oklahoma City-based Baker Group, which advises community banks with over US$45 billion in investments.
"The Treasury is faced with the prospect of having to flood the market with all this supply to fund these deficits." For Ed Yardeni, who coined the term 'bond vigilantes' to describe investors who dump government debt in the face of policies they consider inflationary, it harks back three and a half decades ago. Surging expenditures under President Ronald Reagan sent the budget deficit to a post-World War II record 6 per cent of gross domestic product in 1983, up from 1.6 per cent in 1979, prompting money managers to shun Treasuries.
Ten years later, it was those same investors who famously torpedoed President Bill Clinton's ambitious domestic agenda - forcing him to scale back spending initiatives as long-end rates surged.
Price to pay
"They didn't stop and frisk, they just started shooting," said Mr Yardeni, who heads a research firm that bears his name. "Inflation is key and the market has shown it won't take much for them to push yields higher." As central banks around the world begin to dial back a decade of crisis-era bond buying that's suppressed yields, bond vigilantes will increasingly make their presence felt, he added.
The hit to debt-servicing costs from rising yields will be more powerful than ever. Outstanding marketable securities now total US$14.7 trillion, more than four times what it was 20 years ago.
"Part of the reason we got here is that interest rates have been so forgiving," said Maya MacGuineas, president of the nonpartisan Committee for a Responsible Federal Budget. "But we are about to be reminded that the bond market is not sympathetic to inordinate amounts of government borrowing. The price we will have to pay when rates go up will be quite significant."
To be sure, central banks will continue to limit the extent to which vigilantes can prod officials to curb inflationary policies. The Fed has already signalled its balance-sheet unwind will be slow and that it will continue to hold trillions of dollars in debt securities amassed during quantitative easing. At the same time, easy-money policies in Europe and Japan will continue to support foreign demand for Treasuries.
Moreover, President Trump's recent plan to impose levies on foreign steel and aluminum has fuelled concern that trade wars may be on the horizon, helping stall the 10-year Treasury yield's ascent to 3 per cent amid a flight to haven assets.
And, above all, with long-term government debt yielding a mere fraction of the double-digit levels seen in the early 1980s, there remains significant headroom before debt-servicing costs begin to approach unsustainable levels, according to Mr Coats.
Still, the 40-year bond-market veteran says traders should brace for more violent price swings than they've gotten accustomed to in recent years.
"This is clearly a worry that should be on people's minds," he said. "The vast majority of people on trading desks and running these portfolios have been on the desk for 15 or 20 years. If you are not used to what the volatility can be, there is risk." BLOOMBERG