The disciplanarians of U.S. policy makers return

The Bond Vigilantes. WSJ Editorial
The disciplanarians of U.S. policy makers return.
WSJ, May 28, 2009

They're back. We refer to the global investors once known as the bond vigilantes, who demanded higher Treasury bond yields from the late 1970s through the 1990s whenever inflation fears popped up, and as a result disciplined U.S. policy makers. The vigilantes vanished earlier this decade amid the credit mania, but they appear to be returning with a vengeance now that Congress and the Federal Reserve have flooded the world with dollars to beat the recession.
Treasury yields leapt again yesterday at the long end, with the 10-year note climbing above 3.7%, its highest close since November. Treasury yields had stayed low, and the dollar had remained strong, as long as investors were looking for the safest financial port amid the post-September panic. But as risk aversion subsides, and investors return to corporate bonds and other assets, investors are now calculating the risks of renewed dollar inflation.

They have cause to be worried, given Washington's astonishing bet on fiscal and monetary reflation. The Obama Administration's epic spending spree means the Treasury will have to float trillions of dollars in new debt in the next two or three years alone. Meanwhile, the Fed has gone beyond cutting rates to directly purchasing such financial assets as mortgage-backed securities, as well as directly monetizing federal debt by buying Treasurys for the first time in half a century. No wonder the Chinese and other dollar asset holders are nervous. They wonder -- as do we -- whether the unspoken Beltway strategy is to pay off this debt by inflating away its value.

The surge in the 10-year note is especially notable because its rate helps to determine mortgage lending rates. The Fed is desperate to keep mortgage rates low to reflate the housing market, and last week it promised to inject hundreds of billions of dollars more in this effort. This week the bond vigilantes are showing what they think of that offer, bidding up yields even higher. It's not going too far to say we are watching a showdown between Fed Chairman Ben Bernanke and bond investors, otherwise known as the financial markets. When in doubt, bet on the markets.