How Things WorkMacro Perspectives

How Bond Vigilantes Really Think

Discussions on interest rates tend to fall into two camps – the state based view and the market based view. The state based view says that the government can always control the cost of its interest while the market based view argues that the market (typically “bond vigilantes”) can control the rate of interest. I find both of these views confused or at least misleading.

One of the nice things about being an actual bond portfolio manager is that I see how prices are set every day. I’ve basically spent the last 20 years watching prices change and understanding whether and how I can influence them and try to predict them. I have to know how the instruments work at a fundamental level or I don’t have a job. Now, there are millions of different fixed income markets, but for practical purposes there are two that matter – the risk free short-term market and the risk-filled long-term market. The short-term market is controlled almost exclusively by the Federal Reserve because they have a monopoly supply on the quantity of reserves and the short-term market is largely comprised of risk-free instruments related to these fixed government instruments. So, the Fed can set the interest rate of reserves with near precision. Bond traders know this and so they don’t “fight the Fed”.

The long end is different. The long end is where most of the “free market” risk exists with instruments like 30 year mortgages and whatnot. The government does not set the long end of the bond market and because it’s comprised of greater credit and duration risk it’s much more volatile. So, you can think of the yield curve like a person walking a dog on a 30 foot leash. At the short end near the person’s hand there is virtually no volatility in price because the leash is under tight control. The long end is related to the short-end, but far less controlled. It can and does swing wildly at times. But here’s the kicker – the dog walker is walking in a volatile environment. There is wind, rain and bumps in the road. And so these exogenous forces influence how we walk our dog and how much control we have. In fact, these forces mostly determine how we end up walking and how much control we have.

In terms of interest rates, the outside forces are things like growth, credit risk, financial stability and inflation. These are the things that REALLY set interest rates. We just respond to those forces by trying to walk the dog with as much control as we can. Importantly, the government and the market can try to influence these things, but they can’t control them. 

So, when we think of interest rates it’s useful to consider that short-term rates are controlled specifically by the Fed, but they are really controlled by these exogenous forces because the Fed responds to these exogenous forces. The market is also assessing the state of these exogenous forces and trying to set prices accordingly. Of course, neither the government nor the market can perfectly assess things like inflation and financial stability so a lot of this interest rate fidgeting ends up looking like we’re all chasing our own tails. That’s not to say that we have no control on the outcomes, but governments and markets don’t exactly have flawless records when it comes to predicting how these external forces will play out in the future.

Getting back to bond vigilantes though. When someone like me “sets” prices in the bond market we are mostly responding to these exogenous forces like inflation, growth, credibility, etc. We don’t cause governments to go bankrupt. We respond to exogenous forces and protect prices from the risks associated with those forces. Importantly, the government also can’t control those forces and, just like the bond vigilantes, they are mostly guessing and trying to set prices in a way that hopefully influence the outcomes or protects us from the outcomes.

So, the key conclusion here is this – when people argue that governments can “control” interest rates or that the “bond vigilantes” will bankrupt governments what they’re really saying is that the government and bond vigilantes can accurately predict the future state of unknowable exogenous forces. And while there’s a shred of truth in both arguments they are more misleading than not.

PS – Congratulations if you got this far. You stayed awake through a boring article on interest rates.