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One of the most important signposts for investors is to look for extremes in consensus thinking. For example, at the beginning of the year, investor enthusiasm levels were high, markets were betting on a “V shaped” recovery and worries about the economy’s future were fading fast – at least on Wall Street.

Today, the boat has tilted to the other side as investors have all but surrendered to the idea of a double dip recession or even according to some economists, we are in the “Great Depression”. Seldom have we seen a more heated debate amongst economists about how to best respond to the recent bout of unexpected bad economic data points, stubborn unemployment in most countries and the issues surrounding Europe.

On one end of the spectrum, the economists advocating a Keynesian solution (akin to FDR’s New Deal) are calling for more government spending and stronger monetary policy actions to get things moving. They argue that in the long run, the increased expenditures will be cheaper than the impact of not doing more today.

Listening to this raging debate leaves one with the impression that both sides have valid arguments. However, it seems that the majority of nations have opted to go the route of cutting back spending, ensuring that deficits are reduced and by doing this, they hope to placate the bond markets.

Players in the bond market have often been given the name “Bond Vigilantes” because of their willingness to enforce their own brand of justice on countries that they deem to be too profligate in their spending habits. They try to impose their discipline by forcing interest rates up in countries that are deemed to be risky. As Europe is finding out now, they carry a big stick.

When Bill Clinton was first elected to the presidency, he was furious upon being told that the bond market would not take kindly to a stimulus bill he wanted. As his close political adviser James Carville said:

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.

At this point, it would seem that the bond vigilantes have succeeded in forcing governments to reduce their spending, which should help to keep the much feared inflationary firestorm on the distant horizon for a little longer than expected.

The great fear is whether or not the bond vigilantes will ever turn their attention to the U.S.. So far, one of the beneficiaries of the troubles in Europe has been the U.S. – money has flowed back to the U.S. and into U.S. bonds – forcing interest rates to decline substantially. This has helped to bring down U.S. interest rates. The offset is that the borrowing demand still remains lackluster.

At the recent G20 meetings, Barack Obama was almost alone in advocating more spending to ensure the recovery takes hold. He is in a better position to call for that as the U.S. bond market has had a favorable run as investors panicked and flocked to the safety of U.S. Treasury bonds. But it will not always be that way if present spending trends in the U.S. do not improve. At some point, the bond vigilantes will begin to dole out justice in the U.S. – that could make the European crisis look like a warm up.

The one bright aspect to this is that as Winston Churchill once said – “Americans always try to do the right thing after they’ve tried everything else.” The same can be said for Europe – they seem to have only found fiscal discipline after the bond market demanded it.

Disclaimer: This report is for information purposes only and is neither a solicitation for the purchase of securities nor an offer of securities. The information contained in this report has been compiled from sources we believe to be reliable, however, we make no guarantee, representation or warranty, expressed or implied, as to such information’s accuracy or completeness. All opinions and estimates contained in this report, whether or not our own, are based on assumptions we believe to be reasonable as of the date of the report and are subject to change without notice. Past performance is not indicative of future performance. Please note that, as at the date of this report, our firm may hold positions in some of the companies mentioned.

Disclosure: No stocks mentioned

Source: Eventually, Bond Vigilantes Will Go After the U.S.