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It's not unusual to hear talk about the bond vigilantes, those mythical creatures which, through their buying and selling in the bond markets, enforce fiscal prudence. It's also not unusual to hear the contrary arguments, namely by Paul Krugman, that the bond vigilantes are not to be feared in the liquidity trap we find ourselves in right now.

What I will show here, however, is a third option. It's not that the bond vigilantes are not ready to act. The problem is, most of the bond vigilantes are already dead and the few that are left are held in detainment.

The supposed bond vigilantes have an effect through interest rates, and they influence interest rates by their selling and not buying. What happens is that when a given state leaves fiscal prudence and plunges itself into a fiscal orgy where no debt ever seems too much to bear, then those actors supposed to take on that debt instead take their business elsewhere. By selling whatever debt they hold and not buying new issues, these investors make the debt prices be lower and yields higher. The higher yields, when applied to a large stock of debt, quickly render the whole thing unsustainable. This dynamic was seen in Europe's periphery, but, amazingly, not in the U.S.- even with the U.S. routinely running $1+ trillion fiscal deficits.

So when did the mass killings take place in the U.S.? When were these bond vigilantes taken out back and shot? Why do I say they were shot? The answers lie in the numbers.

The numbers

When we hear talk about the bond vigilantes and their actions, this usually refers to their actions in the long side of the maturity curve. Say in 5 year maturities or longer, up to 30 years. This is so because the short side of the curve is usually mostly dictated by Fed policy and arbitrage of this policy (borrowing at short-term rates enforced by the Fed to buy short-term maturities).

The thing is, Fed's policy as of late has extended mostly to the long side of the maturity curve as well. This is where the killing of the bond vigilantes took place. Ever since the Fed launched QE1, it has been buying up long-term issues. Quite often the Fed buys MBS, but as these mature, the Fed reinvests into long-term bonds. The Fed has also been buying long-term bonds outright, as well as selling short-term bonds and buying more long-term bonds (during "Operation Twist").

The end result of all these Fed actions, was the near-extinguishment of the bond vigilantes. Why do I say so? Because of two effects:

  • One, the Fed bought a substantial part of the 5-30 year existing stock of bond debt. Taking into account a projection for the existence of close to $3.6 trillion in these debt maturities at YE 2012, the Fed presently owns 36.4% of the outstanding stock ($1.31 trillion). Not only that, but the Fed then owns a further $1 trillion in long-maturity MBS, whose sellers probably substantially substituted for by buying U.S. bonds;

  • And two, the Fed is buying $40 billion in MBS and $45 billion in long-term treasuries monthly. This makes for $1.02 billion per year in Fed buying which easily exceeds the expected issuance in the 5-30 year maturity zone over the next few years (see table below for a rough calculation of 5-30 year issuance).

(click to enlarge)

Profound implications

In short, all the Fed buying had and is having profound implications. It means that the bond vigilantes have been selling heavily and could continue selling heavily and still we wouldn't see much of an impact in interest rates. And as soon as the bond vigilantes stop selling for a while, rates are again pressured lower due to the continued Fed buying at a rate which exceeds long-term issuance.

Source: The Bond Vigilantes Have Been Taken Out Back And Shot