Is inflation making a comeback? Federal Reserve policy makers hope so. As bond investors brace for higher inflation, the 10-year Treasury yield has spiked more than one percent since July. Now the market is deciding if wider budget deficits will reawaken deficit hawks known as "bond-market vigilantes."
In late 1993 professional bond traders, concerned about federal spending's impact on the budget deficit, held a buyers' strike, thrusting the yield on 10-year Treasury notes from 5.2 percent to just over 8.0 percent in less than two years.
The Clinton administration and Congress made a political about-face, reducing the deficit in response to high rates. That prompted James Carville, advisor to President Clinton to declare, "I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."
While there's a much larger international bond market nowadays thanks to a global glut of savings, bond market vigilantes could make a comeback should the Trump administration's plans to cut taxes and expand government spending result in big fiscal deficits.
In the event that the vigilantes return, real rates, the yield bond investors require over and above the rate of inflation, would rise. This "distrust premium" would raise government borrowing costs. Historically, bond markets stumble as real rates rise.
Over the last decade or more, fixed-rate bonds, inflation-protected Treasury securities (TIPS) and gold have lost ground on average against a backdrop of higher real rates. The S&P 500 index of large-cap stocks historically advanced as real rates widened, owing perhaps to the stimulative effects of fiscal spending.
The Trump administration's policy blueprints point to wider federal deficits. Perhaps bond market vigilantes could circle the wagons again.