A tall tale of two central banks vs. Bond Vigilantes

A tall tale of two central banks vs. Bond Vigilantes
Key takeaways
“Lowflation” and central bank bond-buying mean bond yields remain very low, despite record inflation
Others worry that as central banks suppress volatility, while inflation continues to rise, Bond Vigilantes could make a comeback. The banks could then hike rates, at a high cost to growth.
Contrasting European Central Bank (ECB) and Bank of England (BoE) reactions to high inflation last decade suggest a more cautious approach, keeping financial conditions loose and portfolios balanced.
“Bond Vigilantes” - missing in action?

Back in the day, the Bond Vigilantes embodied market forces: all-knowing, all-seeing, all-powerful. They were able to dominate markets, economies, even states, by bullying markets into slowing inflation when pliant policymakers or popular politicians were too weak-kneed. They were so powerful, that President Clinton’s chief political strategist, James Carville said that instead of reincarnation as pope or president, he’d return as the bond market, so he could intimidate everyone.

If ever there were a time for the Bond Vigilantes to restore order - absent central bank or fiscal hawks, amid rampant inflation, supply shocks and demand surges - wouldn’t it be right here, right now? Why, then, are the Bond Vigilantes missing in action?

Figure 1. As high inflation faded, so did Bond Vigilantes

Note: Countries use different inflation indexes and central banks target different inflation indexes. The Fed, for example, focuses on a specific measure of core inflation that strips out volatile food and energy, and reflects the heavy historical weight of services in US consumption. But the BoE and ECB in contrast target measures of headline inflation. Here we show indexes that are more directly comparable, but don’t change the story. Source: Bloomberg, Macrobond, Invesco. Data as at 20 September 2021

The consensus that makes sense

The consensus is that quantitative easing has lulled all mere market mortals into the same false sense of security. Even the Bond Vigilantes don’t dare take on central banks that, with easy financial conditions, are willing to create limitless liquidity to sustain growth. Plus, persistent “low-flation” has dominated major economies for decades, perhaps lulling even Bond Vigilantes into a false sense of complacency. Today’s inflation is small compared with the 1970s-80s, the teens or mid-20s in many developed markets and the hyperinflation in some emerging markets (EMs).

The bigger picture

But Bond Vigilantes, by definition, cannot rest easy. They must restore order when the state fails. The truth is that Bond Vigilantes have been selective, not missing in action. They struck with a vengeance in the eurozone (EZ) crisis and in several EMs — Argentina, Russia, Brazil, Turkey, India and South Africa. Yields, risk premiums and volatility surged, credit was crunched, currencies collapsed (some more than once) until macro rebalancing and reform restored stability.

A tall tale of two central banks

Perhaps Bond Vigilantes struck EMs and the EZ Periphery but ignored core markets because they saw more sovereign/credit risk than macro/inflation risk. Which begs the question: What if Bond Vigilantes don’t return despite today’s high inflation? This could leave central banks to be both good cop and bad cop, just as supply shocks boost inflation, demand decelerates, and debt levels are high.

Two examples of above-target inflation in the 2010s – the EZ and UK, complete with market shocks, macro shifts and opposite central bank reactions - offer as close to a controlled experiment as we’re likely to get.

Example 1: BoE hold back twice, during 2009-12 and 2015-18 inflation surges

UK inflation surged on devaluations of sterling following the Global Financial Crisis (GFC) and Brexit Referendum (Fig II). Goods prices rose faster than services, yet bond yields fell as growth slowed with falling immigration and productivity. The BoE cut rates after each shock, only tweaking policy slightly, rather than tightening. This, even though inflation surged from 1% to over 5% after the GFC. Despite lack of policy tightening, growth was weak, bond yields were well-behaved, but equities underperformed.

Figure 2. BoE looked through persistently above-target UK inflation for a decade

Source: Bloomberg, Macrobond, Invesco. Data as at 20 September 2021

Example 2: The ECB hike twice into rising inflation in 2008-2016

EZ inflation doubled to 4% in 2007-08 as the US slid into the Global Financial Crisis, then rose from below zero to 3%, following surging oil prices and a weakening dollar. The ECB raised rates both times despite the recessionary credit crunches during both the GFC and the EZ Financial Crisis. Deflation aggravated the crisis, the hikes had to be reversed, but EZ banks, economies and markets collapsed, threatening the survival of the euro. Germany bund yields went negative, sovereign and bank credit spreads spiraled, equities fell. EZ potential growth has yet to recover. 

Figure 3. ECB hiked twice, preceding two deflations

Source: Bloomberg, Macrobond, Invesco. Data as at 20 September 2021

Central Bank Vigilance vs. Bond Vigilantes

How should central banks react, and market participants rebalance portfolios? This is where the contrast between the ECB and BoE in dealing with supply or currency shocks vs. demand comes in. 

Warnings of persistent inflation due to expansionary monetary and fiscal policies now seem vindicated. But today’s inflation may owe to specific supply shocks – labour, semiconductor shortages, too little wind in Europe causing energy shortages – just as much as demand stoked by fiscal transfers and easy money. Perhaps that’s why the Bond Vigilantes are ignoring the “Inflationistas”.

Clearly, supply disruptions could persist amid continued strong demand, sparking a wage-price spiral and boosting inflation expectations, bond yields and risk premiums. But inflation pressures may also fade in time, as supply shortages clear and demand stabilises. Major developed market (DM) central banks move to normalise policy on the view that the worst of the pandemic is past and risks are tilting towards too-high inflation. The Fed has laid plans to taper asset purchases; the ECB to cut monthly purchases (but not the total); the BoE is ready to raise rates before ending quantitative easing.

It makes sense to address rising inflation risks, but the experience of the UK and EZ also suggests that central banks will tread carefully when facing inflation, due to shocks that disrupt supply and demand. The EZ experience suggests that Bond Vigilantes may see systemic credit risk more than inflation risk if policy is tightened prematurely or mistakenly. The UK experience suggests that looking through supply- or currency-driven inflation may in fact be better – even if it doesn’t restore non-inflationary growth by itself.


The bottom line: Easy does it

The current growth/inflation mix is down to the staccato shot economic shocks of lockdowns and re-openings, unprecedented shifts in the composition of demand, multiple supply disruptions and massive monetary and fiscal policy support. Central banks face a combination of circumstances that are only partly in their capacity to manage. They may well split the difference between the ECB and the BoE – not move to tighten policy so rapidly it threatens to choke off recovery but normalise – but be vigilant to head off inflation risks.

All this points to a slow, stepwise and limited removal of emergency monetary policy to prevent excessive demand growth. At the same time, it allows economies to adjust to evolving supply constraints and shifts in labour markets. Economic normalisation and recovery with supportive financial conditions seems the most likely outcome – which points to gradually, not sharply rising yields.

Related insights

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  • Data as of 30 September 2021 unless stated otherwise.

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