Beware the Bond Vigilantes

Two Bald Men and a Comb

Argentine literary figure Jorge Luis Borges framed the Falklands War as a fight between two bald men over a comb. The image has aged well. The longer the United States and Iran contest the Persian Gulf, the more it will cost the rest of us — and the cost is already being measured not just in lives and matériel but in a variety of economic forces that are slowly building momentum to push core inflation higher.

There is some confusion about which price index is the central bank’s target: all items inflation or core inflation? The target is of course all items inflation, but frequent references to core inflation are made because core inflation is the better predictor of future inflation: if core remains well behaved then all items will converge to core. But at what level?

Since the outbreak of hostilities, oil prices have almost doubled, and while they have recently retreated, supplies are tight and, without the resumption of Gulf supplies, prices are likely to rise.

More consequential for inflation control than the initial oil price spike is the fact that oil prices remain elevated. Markets continue to believe that the shut-in supply of energy and related products will resume once rationality takes hold. But questions of sovereignty do not follow the logic of commercial profit maximisation: one side is focused on survival, the other on dominance. The priors of the trader are not the same as the priors of the politician.

The swing in inflation risk was priced from the very start of this conflict, and interest rates have not just unwound expectations of central bank easing but have swung to tightening. The interest rate market is sending central banks a message they have heard but not yet heeded.

This Is Not COVID

The inflation shock induced by COVID lockdowns and the resulting supply chain disruption saw stagflation concerns rise to become top of mind, a concern that proved to be misplaced. While supply chains have been disrupted again, we should be less certain that inflation can be easily tackled.

COVID inflation was the product of two forces operating simultaneously. The first was excess demand: governments paid people to stay at home, so they could still consume but had nothing to produce so creating excess demand. Second, supply chains could not keep pace with the surge in demand when lockdowns lifted, triggering a necessary relative price adjustment — prices spiked, signalling to producers to increase production to satisfy shortages.

Inflation required monetary tightening because short-term 2% inflation expectations were disturbed and threatened to push medium-term inflation higher as well. This had to be contained. Even though the major central banks were slow off the mark, they managed to contain inflation within the inflation range (usually 1% to 3%), but not at target.

The inflation-control balance today is both more complicated and more dangerous. Inflation has not returned to target, and the fiscal trajectory is simply out of control, with a deficit close to 7% of GDP at full employment. The fact that inflation is already above target cannot be ignored. And the new Fed chair, Kevin Warsh, is untested but is sure to be pressured to ease interest rates in the face of a negative supply shock of extended duration. The margin for error in inflation control is considerably narrower than it was in 2022, as inflation expectations are not as well anchored as they were four years ago.

From Auction Prices to Contract Prices

The risk of higher-than-expected inflation now depends on duration: the longer the energy supply disruption lasts, the more likely it is to feed into core prices and the harder it will be to reverse if inflation expectations become unanchored.

To see why, it helps to look at the flexible and sticky price indexes estimated by the Federal Reserve Bank of Atlanta. They show how a change in relative prices can spread into many other prices. Flexible prices have surged to 5.6%, while core sticky prices have not yet responded as much as one might expect, though they remain elevated at 3.0%. That is still nowhere near 2.0%.

Flexible prices are those repriced frequently, for example durable and semi-durable goods, commodities, and all inputs whose prices are set in auction markets, which respond rapidly to new information. Sticky prices are essentially service prices, such as consulting and transportation contracts, long-term energy supply agreements, insurance premiums, and eventually wages. Contract prices are negotiated at intervals and follow sustained increases in auction-market-determined prices with a lag.

Oil price swings have been highly sensitive to the stream of announcements, reversals, and strategic ambiguity emanating from Washington, and they will move sharply on any credible signal that the Strait of Hormuz will reopen. But an insurance underwriter at Lloyd’s of London, trying to price shipping risk through a contested waterway, cannot rely on that signal alone.

Cargo routes are being rerouted. Marine insurance rates are being renegotiated. Long-term transportation contracts whose terms were set before the Strait closed are now coming up for renewal in an uncertain environment — and uncertainty reliably commands a premium.

Auction prices filter into contract prices slowly. Even if a relative-price increase later reverses, the contract repricing it sets in motion can continue. That is why an oil price increase caused by a persistent negative supply shock tends to push core inflation higher with a lag.

Given that the supply potential of the Gulf has remained constrained for three months, it is now only a matter of time before the future becomes the present and core inflation begins to tick up. Some of the repricing now underway in shipping, other transportation alternatives, and insurance will remain with us six, nine, twelve, and twenty-four months from now — long after energy spot and futures markets have repriced as supply constraints ease.

It’s Inflation, Not the Vigilantes

The sell-off in the long end of the yield curve is widely advertised as the reprise of the bond vigilantes, out to slay wayward sovereigns. Or so the debt fanatics announce with glee.

Some weeks ago we outlined the dangerous state of play in sovereign debt dynamics: debt-to-GDP ratios are now very high across most industrialised countries. Most important is the narrowing gap between financing rates and nominal GDP growth. The long period of low policy rates kept that gap favourable for management of debt dynamics. For most countries other than the United States, the path to fiscal stability is steep but still navigable — though only with political pain.

The steepening yield curve is a welcome signal to sovereigns to find some fiscal discipline, but it is not deliberate. Rather, the long end is more likely pricing the uncertainty around when and by how much central banks will be forced to tighten. A new Fed chair of undemonstrated convictions, under political pressure to ease interest rates, and the sharp rise in consumer inflation expectations measured by survey data are all signaling unease about monetary management and whether it is free to react.

The longer central banks delay showing their hand, the more the yield curve will steepen — and the more likely it is that those hoping for the bond vigilantes to punish profligate sovereigns will be vindicated.

Understanding the signal and intent from the bond market is important. The debt fundamentalists consistently misunderstand or ignore the fact that sovereign debt is not household debt. They can’t go bankrupt. A sovereign can always print money to extinguish a nominal obligation — at which point investors exchange an interest-bearing government IOU for a non-interest-bearing one.

The real debt constraint is not insolvency but the political economy of rising interest expenses crowding out fiscal choice. Poor monetary management will embed an additional inflation premium in interest rates, compounding the rate of debt growth and stressing all asset markets.

The debt fanatics understand the effects of fiscal indiscipline even if they confuse cause with effect. Their language is dramatic, but their fear of what high debt can bring is well placed. We should take no comfort from today’s fiscal fragility and the vulnerabilities created by fiscal mismanagement. Default is not the threat; financial instability is. The risk of another financial crisis is growing.

The Equity Market’s Binary Future

Equity market values are eye-wateringly high, signaling eye-watering levels of risk, but investors buy into tech stocks on the grounds that both today’s and tomorrow’s earnings growth justify the risk. Maybe. If so, then value remains good and the risk of loss low. If future earnings don’t show, then value is bad and the risk of loss high. The CAPE is just 10% below its high of 44.2 in December1999, and the equity return after that was -3.7% over the ensuing ten years.

Moreover, additional vulnerabilities accompany the current moment, namely the troubling self-funding dynamics between the hyperscalers and the semiconductor manufacturers; some correction in that complex will surely come.

For now, the equity market is happy to blow away the froth and take that risk, but it is ignoring the signal coming from the bond market. As the 2008–2009 financial crisis unfolded, corporate bonds priced the risk earlier than the equity market. This time around, corporate bond spreads are near their lows even as the sovereign bond market signals trouble. If the inflation risk goes unmanaged as it did in early 2022, all assets priced to the sovereign will be in for a rough ride.

A Good Crisis Should Never Go to Waste

There is significant political pressure on the US administration to find a face-saving exit from the Persian Gulf conflict, necessary to restore the 20% of world oil supply flowing through the Strait. While we should remain alert to the risk that a supposedly transitory inflation shock becomes a stubborn inflation process, a clean end to the conflict will likely rein in the surge in long-term rates. But the danger is that this episode will be written off as a near miss, with no lesson learned. Yields may not pull back quickly to their pre-war levels.

The bond market is signaling that a fight is brewing between monetary and fiscal policy which could spill over to a painful and difficult struggle for dominance. The longer central banks wait to show their cards, the more expensive the inflation remedy becomes, and the more difficult will be the serious work of stabilising debt dynamics.

The bald men’s fight over the comb is a sideshow — the fight we should be having is over inflation control, and the bond