Bond Vigilantes Are Out There; Here's What You Need to Know

Two weeks ago, when the January jobs report showed wage gains up 2.9% from a year ago, triggering inflation fears, the bond market freaked out and stocks started tanking.

That's behind us now. Or is it?

Sure, stocks have recovered and the 10-year Treasury yield is lower, but inflation fears are still out there - and that means bond vigilantes are lurking in the shadows and could hijack markets again.

Here's the truth about inflation, the origin of these bond vigilantes, and how the market will react to all of this...

The Great Bond Massacre

Bond vigilantes are Treasury bond market investors and traders who protest monetary or fiscal policies they consider inflationary by selling and shorting Treasury bonds, which increases their yields.

They're vigilantes because they theoretically act as a restraint on the government's ability to overspend and overborrow by raising borrowing costs as they push interest rates higher.

The term first originated in 1993 during the Clinton administration, when bond sellers pushed U.S. 10-year yields from 5.2% to just above 8.0% over market concerns about federal spending.

That sell-off became known as the "Great Bond Massacre."

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Starting last September, with U.S. GDP growth already expected to pick up, new bond vigilantes began selling Treasuries anticipating that massive tax cuts and the president's push for infrastructure spending would stimulate the economy above trend and spark inflation.

From just above 2% in September last year, 10-year yields spiked to 2.85%. When higher-than-expected wage gains numbers came out two weeks ago, the 10-year yield shot up to 2.95%, a four-year high, triggering an across-the-board stock market sell-off.

Now, with stocks having recovered three-quarters of their losses and the 10-year Treasury yield back down to 2.84%, stock and bond investors seem to think inflation fears are overblown.

It's Called the "Amazon Effect"

Treasury Secretary Steven Mnuchin weighed in last week on what he considers overblown fears, saying "there are a lot of ways to have the economy grow... You can have wage inflation and not necessarily have inflation concerns in general."

For the most part, he's right.

While the unexpected uptick in wage gains is an inflationary additive, gains aren't necessarily sustainable, and other inflation measures remain at bay, for the time being.

The rate of inflation, using the Fed's preferred PCE index (Personal Consumption Expenditures Price Index), rose to 1.7% last year from 1.2% in 2015. It was just 0.3% in 2014.

However, the CPI (consumer price index), which analysts say better reflects what Americans pay for goods and services, was running at a 2.1% rate at the end of 2017.

That's not a big deal. The Fed's been trying to get inflation up to a 2% level for years now. If we're there based on the CPI, that shouldn't surprise anyone. In fact, it should be healthy.

The fact is it's been a decade since inflation reached 3%, a level that would be concerning. We're nowhere near that and probably won't get there for a long time to come.

Lots of factors are dampening inflation and wage inflation in particular, including a huge move toward automation, global competition, and online shopping - with its price comparison advantage, or "Amazon effect."

Customers can see prices from all over the world, making it harder for companies to raise prices and make them stick.

With no real inflation immediately in front of us, or out in the future, it doesn't make sense that bond vigilantes would be selling bonds causing yields to spike.

But they did and may well start doing so again.

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We're Not Out of the Woods Yet - Be Vigilant

If GDP growth starts to rise above trend, which has been 1.5% to 1.75%, that would be one arrow in their quiver.

The Atlanta Fed's GDPNow report sees GDP growth at 4%. That would be a shock to the system and bring out the vigilantes.

As the massive tax cuts enacted last year put more money in consumers' hands, more money in corporations' hands, and generate more spending across the economy, inflation could rear its head at a much faster rate than anyone expects.

And if the Trump administration is successful in generating lots of infrastructure spending while adding to already towering deficits, there'll be even more money floating through the economy as building generates jobs, production, manufacturing, and spending. All inflation inputs.

They're out there.

The bond vigilantes are only resting, having pushed the yield up on the 10-year almost 50% in less than six months. If markets get back on track and the economy perks up as it's expected to, bond selling will pick up along with the expanding economy and inflation fears.

We're not out of the woods.

What's important to watch is what happens when the 10-year yield gets to 3%, which is coming.

If the hard selling by vigilantes pushes the 10-year yield above 3% - meaning 3.10% to 3.25% - the losses on existing bond portfolios will be staggering and will spur cross-asset selling.

That means stocks will drop again if bond yields spike.

You've been warned. Now, be vigilant.

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The post Bond Vigilantes Are Out There; Here's What You Need to Know appeared first on Wall Street Insights & Indictments.

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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