When Bond Investors Become Vigilantes

Years ago, I had the opportunity to ask former Secretary of the Treasury Lawrence Summers a question. As he walked in one direction and I in the other, when our paths crossed, I said that I taught economics and wondered what he thought was the most important idea my students could learn. Barely pausing, he said, “the power of the market,” and continued onward.

Rather than a place, a market is a process. Composed of many buyers and many sellers, markets function from the bottom up. With no one telling anyone the price of whatever is traded and how much to exchange, countless individuals decide. No one person or group makes the decisions. Instead, we have the power of the market when together, all transactions determine a price.

This week, bond markets demonstrated their power.

Bond Markets

The Markets

Naming the sellers and buyers in bond markets, we can start with national governments. To make up for spending that exceeds revenue, the U.S. government sells bonds. Also, smaller governments like cities and towns borrow. by selling bonds. In addition, corporations use the bonds they issue to raise money for expansion. However, it is also possible that a bond represents a “package” containing items like mortgages.

Bonds can be sold by the issuer in a primary market or by any other bondholder that sells in a secondary market. But, whether we are looking at a seller or a buyer, a primary or secondary market, the common thread is a loan that usually has a payback date (maturity) and an interest rate.

The interest rate takes us to the power of the market. Sort of like Goldilocks, buyers do not want to receive a rate that is too low and sellers don’t want it to be too high. The market makes the decision.

And that takes us to the vigilantes.

The “Vigilantes”

Called the vigilantes, we have a group of bondholders that care about the rise and fall of the U.S. deficit. Concerned that (what they view as) excessive government spending is inflationary and unwise, the vigilantes sell their bonds. As a result, bond prices plunge and interest rates rise. (For example, a $100 bond that pays $5 interest has a 5% rate. If sellers increased supply, and bond prices descended to $90, that $5 interest payment became a 5.56% rate.)

Since higher rates increase the cost of borrowing, governments, corporations, home buyers, and car buyers are unhappy. So, when the bond vigilantes nudge rates upward, the U.S. government notices. With the (so called) “One, Big, Beautiful Bill,” when rates rose, believers in the vigilantes said the message was irresponsible legislation.

From a recent April 3rd low of 4.06 percent, 10-year Treasury yields climbed to 4.54 percent on May 22nd:

Our Bottom Line: Bond Vigilante History

Economist Ed Yardeni tells us that he started calling bond investors vigilantes on July 27, 1983. As he explained, “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.” He emphasized that they were not consciously dictating the market. Instead, knowing that inflation reduces the value of their return, they sold their bonds.

Like today, they were responding to the fiscal policies that elevate the inflation rate and “excessively stimulative” monetary decisions that lower interest rates.

My sources and more: For a quick read and listen, this article and this video convey a good summary of the bond vigilantes. Then, among many possibilities, the NY Times had some analysis.