If stock investors are glum, then bond investors must be downright depressed. The combination of rising inflation and aggressively tightening central banks has led to one of the worst years for bonds since the early 1980s. As of this writing, both high quality corporate bonds and Treasury bonds are down about 15% for 2022, losses that swamp any income that’s expected to be received from these securities. Bond investors have been rudely awakened from their slumber, and a new gang of bond vigilantes has risen from their complacency.
“Bond vigilantes” is a term coined by economist Ed Yardeni during the major bond bear market of the early 1980s. As the moniker implies, these “vigilantes” supposedly took the laws of finance into their own hands and pushed back against the evil forces of inflationary government policies of the time.
“Bond investors are the economy’s bond vigilantes”, Yardeni once declared. “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.” As he later spelled out: “By vigilantes, I mean investors who watch over policies to determine whether they are good or bad for bond investors … If the government enacts policies that seem likely to reignite inflation”, Yardeni elaborated, “the vigilantes can step in to restore law and order to the markets and the economy.”
These investors are not acting out of altruism. While the word “vigilante” implies some higher moral calling, the plain fact of the matter is that large bond holders, including pension plans, are dumping bonds to staunch the flow of red ink. Mathematically, bond prices FALL as interest rates RISE so that the interest payment equates to the prevailing market percentage yield. The reverse is true also, that bond prices RISE when rates FALL, which led to bumper returns for bondholders during the 2009-21 period of “quantitative easing’ (QE) which artificially held interest rates near zero.
We speculated in past Market Outlooks that if high inflation returned, global central banks’ QE policies would backfire. For years QE was beloved by Wall Street as it created a (seemingly) never-ending fount of central bank cash that found its way into stocks, bonds, and real estate, creating a virtuous circle of fuel (i.e., cash), demand, and higher asset prices. Now it has become clear that these same policies have helped fuel today’s inflation, and additional QE, far from being welcomed by vigilantes, is viewed as fanning the flames of even higher consumer prices.
No nation is more acutely aware of the power of this newfound vigilantism than Great Britain. On September 23rd, the new prime minister, Liz Truss, proposed a “mini budget” designed to spur growth to counteract Europe’s energy crisis and the recessionary effects of Britain’s decision to pull out of the European Union (Brexit). Unfortunately, the new plan relied heavily on tax cuts and spending increases funded by more government borrowing, made possible by more QE.
The market’s reactions were swift and merciless, as UK interest rates leaped in the days following the announcement, and the British currency plunged to record lows. The reaction spread worldwide, affecting virtually every class of security. A more spectacular example of the power of bond vigilantism would be hard to find, and Mrs. Truss paid for it with her career, becoming the shortest tenured prime minister in British history with just 38 days in office.
The effects of the bond vigilantes’ efforts can also be seen in the “yield curve” of interest rates. The yield curve measures the different rates of interest paid by various maturities across the Treasury bond spectrum. Normally, short-term yields are lower than long-term yields, as investors require higher compensation to part with their money for longer periods. This relationship holds 99% of the time.
When the yield curve “inverts” short-term rates are higher than long-term ones. The general message from an inverted yield curve is that restrictive monetary policies are taking hold, and financing is getting harder, and more expensive, to get. Since our economy runs on credit, this has a dampening effect on business. The practical effect of this can be seen in the tightening of banks’ lending standards to their customers. Sharp-eyed readers will note that this has occurred prior to each of the last four recessions (shaded vertical bars).
Nothing would make the bond vigilantes happier than a nice recession to stifle current inflationary pressures and bring interest rates down, giving them a reason to buy bonds rather than sell them. The bond market, like the stock market, is spinning narratives weekly to explain the behavior of the market. The current yield curve inversion has bond investors hopeful that a recession is in the cards.
Should investors take advantage of the bear market in bonds and start adding them? Without question yields have become more attractive, especially compared to the last 13 years, but with the US Fed and their global cohorts bulldozing ahead with interest rate hikes it seems a precarious time to make a bullish bet on bonds. We would advise investors to keep bonds on the radar screen for purchase, and consider using the point-and-figure chart of TLT, the long maturity Treasury bond ETF, as the guide to timing. When this chart gives a bullish signal, it will be safe(er) to wade back into the bond market. Readers can contact us to get an update on TLT’s status at any time.
The psychological environment certainly supports the idea that a bottom could be close to hand for bonds and stocks. Bond investors are nursing losses they haven’t experienced for 40 years, while stock buyers are longing for the easy money days of the last few years, when “buying the dip” was the only analysis they had to do.
One clue to the state of mind of the retail investor is that short-selling stocks, even at these depressed levels, is enjoying widespread popularity. Short selling is a technique by which a security can be sold first in the expectation that the price will fall, and is then bought back at a lower price. It is a perilous tactic that is rife with risk, but seems to have caught the fancy of the day-trading crowd. Of course, this is the mirror image of their rabid bullishness of early 2021, when stocks were hot commodities, and these same investors were borrowing on margin to leverage their gains. Short-selling behavior on the part of “retail” investors may provide a contrarian opportunity for others. In other words, when the crowd is bearish, it’s time to look for reasons to be bullish.
But simply being a contrarian is a weak reed to lean on in this environment. Investors should look for confirmation that the trend is changing before making bullish bets. The chart of TLT provides this tool for bond investors, and the oft-featured chart of the NYSE advance/decline (a/d) line provides one for stock buyers.
The NYSE a/d line continues to be in a major downtrend, though the rightmost column has reversed to Xs, indicating recent strength. Over the summer, it had moved to bullish status, but resumed its downward path after a few weeks. Investors continue to try to handicap the bottom, but have been frustrated as their bullish predictions have fallen flat. This is helping to create the sort of environment where investors give up on stocks, throw in the towel, and move everything to cash. Should the a/d line move to bullish status at about the same time, it would present a major opportunity for stock investors. We’re not there, yet.
Since 2009, both bond and stock investors have become conditioned to quick recoveries facilitated by the Fed’s panicked liquidity injections. With inflation now guiding the Fed’s policies, success is likely to come to investors with the greatest patience, not the quickest trigger fingers. Bond vigilantes appear to have the upper hand at the moment, so investors should expect interest rates to call the tune for bonds and stocks. But the obsession with rates and inflation is masking what is happening under the surface of the popular stock indexes, some of which is decidedly positive. As always, investors should focus on what is happening, rather than what should be happening, and wait patiently for the bond vigilantes to ride out of town.