Bond vigilantes are a popular topic in financial media. Part of this is that most people find government bonds boring, and they would rather read about equities, which can have more exciting returns as well as more interesting company and sector specific stories. Bond market vigilantes who are about to discipline naughty governments creates a fun narrative hook to a market that is otherwise characterised by daily price changes of around 20 basis points.
However, if you are actually paid to invest in bonds, the “bond vigilante” narrative is a trap. Government bond markets are boring, technical markets, and you do not want to get wedded to some directional thesis just because it feels good. You end up wasting part of your valuable risk budget on duration bets — which in practice almost nobody in fixed income has a track record of consistently making money on.
The Truss/Kwarteng Episode
Vince Gomez has an article on the 2022 gilt market scare in the U.K. when it had the hapless leadership of Prime Minister Truss and Chancellor of the Exchequer Kwarteng. As I wrote at the time, this episode is now highlighted whenever the possibility of loosening fiscal policy in the U.K. is raised.
However, the mythology around the episode ignores key points that are discussed in the article (and I discussed earlier). Although the incompetence of the Truss government helped trigger the panic, the panic was the result of U.K. pension funds somehow managing to completely hose the liquidity management of the derivatives portion of their Liability Driven Investment (LDI) strategies in 2022, just over a decade after the 2008 Financial Crisis demonstrated the importance of liquidity management. Given all the hand-wringing about systemic financial risk by regulators and central banks since that earlier crisis, the rather flat-footed response by the Bank of England to the 2022 panic is puzzling.
The article has a useful graph that shows that gilt yields tracked U.S. Treasury yields, and that without labelling the episode, the Truss Crisis does not stand out on the time series. One could argue that this was the result of the Bank of England intervention before things got too ugly, so I would be cautious about arguing that point.
The Full Funding Rule
The Gomez article argues that the “Full Funding Rule” used by the U.K. Debt Management Office is misguided. As stated in the 2025-2026 report (link):
An overarching requirement of debt management policy is that the government fully finances its projected financing requirement each year through the sale of debt. This is known as the ‘full funding rule’. The government therefore issues sufficient wholesale and retail debt instruments, through gilts, Treasury bills (for debt financing purposes), and NS&I products, so as to enable it to meet its projected financing requirement in full. [page 8]
This rule is designed to aggravate fans of Modern Monetary Theory (and Positive Money, which has a following in the U.K.). However, it is effectively meaningless. The consolidated U.K. central government “finances” its net deficit by the issuance of liabilities, which are both gilts and the expansion of the monetary base (“money”). (I used “net deficit” loosely as a synonym for “financing requirement” as there might be a gap between the fiscal deficit and net cash expenditures.) Since the balance sheet of the Bank of England is balanced, it needs assets to cover its increased monetary liabilities — and it owns gilts. Which means that the gross issuance of gilts has to match the increase in governmental liabilities.
The only way to not have gilt issuance match its “financing requirement” is for the Bank of England to break double-entry balance sheet accounting. Some people have argued that “money is not really a liability” so they are amenable to this approach, but there is no point in making arguments that will be ignored by everybody with a knowledge of accounting.
Fed Independence
Hopping to the other side of the pond, I periodically see hand-wringing about Fed Independence. Earlier in the Trump II regime, he was bulldozing the limits on Presidential power, and one could have imagined him installing some 20-year old sycophant as the rate-setting authority in the Federal Reserve. However, the ongoing political disasters due to bad decision-making by the White House makes such scenarios less likely. (The current projected line up for the 250th American Anniversary concerts currently consists of Vanilla Ice and somebody else, which is a humorous statement of the political momentum behind Trumpism. I am hoping that Vanilla Ice does not back out, as that is the funniest possible outcome for those of us who were in our peak music listening years in the early 1990s.)
Even if Trump installs lapdogs at the Fed, those lapdogs still need to win the votes on rate policy. With midterms coming up and President Trump approval ratings in the 30s, it is going to be hard to get people to commit career suicide by doing something really stupid with interest rates.
More realistically, they might be able to get the policy rate 50 basis points lower than otherwise. The economy is not that sensitive to interest rates, and that would not really matter for anything other than betting on money market forwards.
And even if Trumpists can surpass that 50 basis point level, we cannot ignore our friends, The Bond Market Vigilantes. Even though financial market participants are going to cut Republican Presidents a lot of slack, are the bond markets really going to ignore an inflationary accident? All it would take is a weekend of scary financial market prognostications to cause the President to panic and flip course. Even though I do not take the Bond Market Vigilantes seriously, there is no reason to believe that is not going to be true of the White House.
Which explains why I see little value in worrying about Fed Independence for anything other than tactical rate positioning (which is admittedly a popular side-line for rates investors).
Going Quiet Shortly
On an editorial note, I have been distracted by finishing a consulting project and springtime renovation projects before I head out for a couple of weeks. I might be able to get a piece off next week, but will likely be quiet thereafter (unless there is breaking Vanilla Ice news).
No comments:
Post a Comment
Note: Posts are manually moderated, with a varying delay. Some disappear.
The comment section here is largely dead. My Substack or Twitter are better places to have a conversation.
Given that this is largely a backup way to reach me, I am going to reject posts that annoy me. Please post lengthy essays elsewhere.