Bond Vigilantes Awoken by Obama Tax Plan, Deficit, Yardeni Says

President Barack Obama is inciting the wrath of bond investors concerned that his agreement to extend and expand tax cuts will keep the federal deficit at record levels, according to economist Edward Yardeni.

“You are kind of seeing the bond vigilantes waking up in the United States,” Yardeni, president and chief investment strategist at Yardeni Research Inc., said by telephone in a Bloomberg Television ‘Inside Track’ interview from London. “It does seem to be a coincidence between this recent significant back-up in bond yields and concerns that Washington finds it all too easy to increase the deficit by extending the tax cuts and adding other tax goodies.”

Yields on 10-year Treasury notes posted the biggest-two day rise in two years after Obama said late Dec. 6 that he’d accept a deal that would extend current tax rates for high-income taxpayers for two more years in exchange for extending federal unemployment insurance for the long-term jobless and cutting the payroll tax by $120 billion for one year.

Yardeni, who coined the term bond vigilantes in 1983 for investors who protest inflationary monetary or fiscal policies by selling bonds and driving up government borrowing costs, estimated that yields on 10-year notes should rise by about 1 percentage point to 4 percent to 4.5 percent based on U.S. growth.

“If I had to bet on who wins the contest between governments and the bond vigilantes, the bond vigilantes would always win because they are in a position to threaten to shut the bond markets down and not finance anything unless governments start to move away from reckless monetary and fiscal policies,” said Yardeni, who is based in New York.

Prior Administrations

The vigilantes had their heyday in the late 1980s and the early 1990s when they succeeded in forcing President George H.W. Bush and then Bill Clinton into adopting politically unpopular tax increases and spending cuts to reduce the budget deficit.

The federal deficit totaled $1.3 trillion in the fiscal year that ended Sept. 30, according to the Congressional Budget Office. The White House budget office projected the federal deficit this year will exceed $1.5 trillion, or 10.6 percent of gross domestic product.

“We are moving in the wrong direction in the U.S.,” Yardeni said. “At the end of the day, we’re probably going to find that financial markets generally speaking will reward those who are moving away from reckless monetary and fiscal policies.”

Inflation Expectations

Federal Reserve Chairman Ben S. Bernanke’s “message to the bond vigilantes was that, ‘we’re not going to have deflation’ and he’ll do whatever it takes to avoid deflation,” Yardeni said. “The fact that he said he could get inflation back to 2 percent, that doesn’t have a lot of credibility because if he’s so good at keeping inflation pegged at exactly 2 percent then why are we below that? There’s a fear he may overshoot and that’s another reason to lighten up on the bond market.”

Consumer prices in the U.S., excluding food and fuel increased 0.6 percent in October from a year earlier in the smallest gain in year-over-year figures going back to 1958, the Labor Department reported Nov. 17. The personal consumption expenditures index, excluding food and energy, which is the Fed’s preferred gauge for consumer prices, rose 0.9 percent in October from a year earlier, a government report said Nov. 24.

The 10-year note yield fell five basis points to 3.23 percent at 10:04 a.m. in New York. The yield rose 35 basis points over the past two days in the biggest two-day slump since Sept. 19, 2008, when the markets were in upheaval following the bankruptcy of Lehman Brothers Holdings Inc.

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