The Retired Investor: High Noon for the Bond Vigilantes

It was to be expected. Financial markets almost always confront a new Fed chair. That may still be true, but Kevin Warsh isn't the one in the firing line. It is the U.S. Treasury Secretary Scot Bessent.

 

The bond vigilantes have had their way in the bond market recently. When Kevin Warsh took over the Fed in May, he made it clear the Fed would take a back seat and let the markets set the proper level of interest rates, at least on the long end. OK, said the bond vigilantes, let's see what you got.

 

Since then, fixed income traders, or bond vigilantes as Wall Street calls them, have trashed the 10-, 20-, and 30-year U.S. Treasury bonds. They have sold or shorted bonds, sending yields on the thirty-year higher than at any time since 2007 (just before the Financial Crisis). The U.S. ten-year benchmark bond yield hit 4.50 percent as well, with strategists predicting it's on its way to 5 percent. Around the world, the same thing was happening in other countries' fixed income markets. Why?

 

The continued rise in oil prices, record deficit and debt levels, rising interest costs, and demand for borrowing were too much weight on one side of the scales. Up until this week, equity markets tried to ignore the moves; despite strong corporate earnings fueled by the enormous boom in AI infrastructure investment, they faltered.

 

Truth be told, some of that AI investment has also been an issue. Worldwide, companies that need trillions of dollars more in the AI race have been tapping bond markets globally for funds. That has set up further competition between private and public needs in the borrowing arena worldwide.

 

This was not what the administration wanted to see, at least here in the U.S. The stock and bond markets have become the lynchpin of success for a president already battling a multitude of negatives with midterms less than three months away. Something had to be done and fast as yields ticked higher and markets crumbled on Wednesday a week ago.

 

In this financial gunfight steps the government's financial sheriff, a hedge fund manager by trade, and one of the real gunslingers in town. Scott Bessent, Secretary of the U.S. Treasury, announced his department planned to double government debt buybacks, beginning in September, to the tune of $4 billion. Bond yields immediately tumbled, and the stock market surged.

 

The Treasury's purchases, he said, will target the long end of the yield curve where the bad guys had shorted massive amounts of long-dated Treasuries. To pay for this added expenditure, investors surmised that the Treasury will probably need to sell even more bills and bonds on the short end at their weekly auctions. And herein lies the rub.

 

Unlike the Federal Reserve Bank, the Treasury cannot print money. They indeed have a lot more money than any single bond vigilante, but it's not inexhaustible. The Vigilantes, after a day or two of indecision, were back to their old tricks and yields began to rise again. To gun down the guys in the black hats, Bessent would need more than a couple billion.

 

So, a few days later Treasury people floated the story that they could use the Treasury's almost $1 trillion General Account (the government's checking account) to finance the purchases. Nobody said they would, but the threat was enough to at least push yields down slightly on government bonds this week.

 

Wall Street immediately mounted up the free-market posse. From their high horse, various well-known managers decried this interference in the free-market system where price discovery is the bible in determining the worth of any asset. "Let the bond market speak," said one famed investor. Interesting how that works. It's OK for the government to buy shares in various companies, bail out industries, determine how much companies can sell and to whom, but don't mess with something so sacrosanct as the nation's Treasury markets.

 

Will Bessent's plan work? In the short term, he had stemmed the rapid rise in yields that had thrown the stock market into a dizzy. Both the 10-year and 30-year bond yields had moved down by about 10 basis points. However, Friday's speech at the Jackson Hole Economic Forum threw a wrench into Bessent's play.

 

The Fed chief made it clear that the Fed had more work to do on the inflation front. Markets took that to mean an interest rate hike could be imminent. Bond yields went right back up and are now trading at yields higher than before Bessent's announcement. It appears the Fed and the U.S. Treasury are working at cross purposes.

 

Critics say that without fixing the underlying causes of the backup in interest rates — government spending, inflation, debt, etc. — his efforts are no more than a pimple on an elephant's derriere. They may be right but don't be surprised that in the days ahead, Bessent decides to increase the amount of bond purchases the Treasury makes.

 

Next week, I will discuss where the Fed stands and why this could simply be part of a developing and ongoing plan first mentioned to readers in my columns on sovereign wealth funds back in June.