Time for the vigilantes?

We await the Fed’s report on the Silicon Valley Bank crisis, is that policymakers were allegedly flabbergasted by the speed at which deposits were withdrawn and the bank failed.

One of former president Clinton’s advisors, James Carville famously said that if there is reincarnation he wants to “come back as the bond market. You can intimidate everybody”. He said this after a particularly tense stand-off between Clinton’s budget policies and the so-called bond vigilantes in the treasury market.

Some might see such alleged vigilantism as arcane these days, and certainly not always welcome. But, in some senses it can be a force for good and we might even find this out during the ongoing debt ceiling row between the Republicans in Congress and the White House.

At the heart of this debate is whether vigilantism in any asset (as it does not just have to be the bond market) drives necessary policy changes, or just serves as a means for speculators to make outlandish profits. It is no wonder governments don’t like the vigilantes but, in some ways, they might be doing policymakers a favour.

The last notable case of such vigilantism was in the UK gilt market after the former Chancellor Kwarteng delivered an incredibly reckless mini-budget last September. The subsequent surge in gilt yields and near collapse of some pension funds bought about a much-needed policy volte-face. Had the gilt market not crumbled that mini-budget would have probably been passed into law and Liz Truss would probably still be PM. The fact that she was defeated by the bond vigilantes could be seen as a good thing as such unfunded tax cuts might have continued and got the country into all manner of trouble in time. With fiscal discipline restored – by the vigilantes and new Chancellor Hunt - the gilt market has recovered.

Could the vigilantes be called upon in the case of the ongoing debt-ceiling impasse in the US? Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said it would certainly seems possible. But the difference here is that it might not be bond vigilantes that apply the most pressure because, unlike the UK gilt market, the treasury market still has safe-haven attributes that could help insulate it even if the debt ceiling impasse turns really nasty. This is what we saw the last time the situation really darkened back in 2011 when treasuries were reasonably stable and it was the stock market that plunged after S&P delivered its verdict– by stripping the US of its AAA credit rating.

An interesting question now is whether financial market vigilantes, in bonds, stocks or even currencies could flex their muscles the closer the government gets to running out of cash. In other words, might we only expect market mayhem if politicians fail to raise the limit  in time and the US goes into a technical default, or might sufficient pressure be applied by the market ahead of the so-called X-date, such that the politicians put their differences aside and agree a deal that might otherwise fail to arrive? If things work out this way the vigilantes might have done the US a favour, not a disservice. But is this likely? Will the market blink first if things seem to be going right down to – or beyond – the wire, or will they wait, supposedly safe in the knowledge that a deal will be struck in time?

Most likely it will be a bit of both in Mr. Steve Barrow’s view. There is likely to be some build-up of pressure in terms of things like weaker stocks, higher yields in those short-term assets that might not get paid out, and a weaker dollar. But it won’t be on a par with what we would see if the US falls into technical default, or perhaps even if a technical default is averted but rating agencies take the US down another notch. One other thing to bear in mind here, as we await the Fed’s report on the Silicon Valley Bank crisis, is that policymakers were allegedly flabbergasted by the speed at which deposits were withdrawn and the bank failed. This surely must be a warning that, when it comes to the debt ceiling, if there is some sort of run on the US either before, or after the X-day, it could be much faster and probably much deeper than we’ve seen before.

In short, the stakes seem much higher and investors will just have to hope that the politicians appreciate this.