EC How Bond Vigilantes Really Think

Discussions on interest rates tend to fall into two camps – the state based view and the market based view. The state based view says that the government can always control the cost of its interest while the market based view argues that the market (typically “bond vigilantes”) can control the rate of interest. I find both of these views confused or at least misleading.

One of the nice things about being an actual bond portfolio manager is that I see how prices are set every day. I’ve basically spent the last 20 years watching prices change and understanding whether and how I can influence them and try to predict them. I have to know how the instruments work at a fundamental level or I don’t have a job. Now, there are millions of different fixed income markets, but for practical purposes there are two that matter – the risk free short-term market and the risk-filled long-term market. The short-term market is controlled almost exclusively by the Federal Reserve because they have a monopoly supply on the quantity of reserves and the short-term market is largely comprised of risk-free instruments related to these fixed government instruments. So, the Fed can set the interest rate of reserves with near precision. Bond traders know this and so they don’t “fight the Fed”.

The long end is different. The long end is where most of the “free market” risk exists with instruments like 30 year mortgages and whatnot. The government does not set the long end of the bond market and because it’s comprised of greater credit and duration risk it’s much more volatile. So, you can think of the yield curve like a person walking a dog on a 30 foot leash. At the short end near the person’s hand there is virtually no volatility in price because the leash is under tight control. The long end is related to the short-end, but far less controlled. It can and does swing wildly at times. But here’s the kicker – the dog walker is walking in a volatile environment. There is wind, rain and bumps in the road. And so these exogenous forces influence how we walk our dog and how much control we have. In fact, these forces mostly determine how we end up walking and how much control we have.

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Gary Anderson 4 weeks ago Contributor's comment

Well, I question this article. Art Cashin warned bond vigilantes a few months ago to behave. That means they exist, but they are cautiously unwilling to buck Cashin, since Cashin''s main concern is to protect the collateral.