Governments promise. Markets price.
In Yes Minister, Jim Hacker would occasionally discover that, however grand his political ambitions, someone unseen had already decided what was possible. Modern politicians often make the same discovery when they meet the bond market. There is a cynical school of thought that the role of government is to dispense political favours and money to its supporters. Politicians and voters therefore become frustrated when they are told that the “bond market” prevents them from handing out free money. They then ask: who is the bond market, why is it so powerful, and who elected it?
Some governments like to spend or to give money away to their supporters in the form of benefits, healthcare, or occasionally education. Others place more emphasis on tax cuts for their supporters, but they too enjoy giving money away. Most government spending is funded through taxation, but not all of it.
Many governments do not raise enough tax to cover their expenditure and must therefore borrow. The United States, for instance, raises about $3,320 billion in tax revenue but spends around $4,300 billion, leaving a deficit of nearly $1,000 billion that must be financed through borrowing. The US government could turn to local banks for this, but that would be like going to a corner shop to buy a fleet of bulldozers. Instead, it turns to the bond market – the wholesale venue for borrowing – rather like going directly to JCB, Caterpillar, or Komatsu to purchase heavy machinery.
The bond market is where governments, high street banks, and large companies go to borrow money. They are borrowing from savers: pension funds, insurance companies, investment funds, hedge funds, and occasionally wealthy countries that choose to invest for the future rather than spend – countries such as Norway, Singapore, and some Middle Eastern nations, including the UAE.
Behind these institutions are ordinary men and women – money managers – whose job is to assess risk and earn a positive return for their savers. They cannot afford to invest in countries or companies that may fail to repay their debts, or in currencies where inflation erodes the value of their investment. Money managers have a fiduciary duty to act in the best interests of their clients. The higher the perceived risk of default or inflation, the harder it becomes to borrow, and the higher the interest rate that must be paid.
Government and corporate borrowing takes the form of bonds; essentially long-term IOUs that pay a fixed rate of interest over their life. The average maturity of US government debt is about six years and around thirteen years in the UK. These bonds can be bought and sold in the market. When bond prices fall, interest rates rise, and vice versa. If money managers lose confidence, they sell; prices fall and interest rates rise. If they are confident, they hold or buy.
The former CEO of Citibank, Walter Wriston, famously said, “Countries don’t go bankrupt.” He was wrong. Shortly afterwards, the Latin American debt crisis brought Citibank to its knees and required government support. Governments do default: in recent years, Lebanon, Ghana, Sri Lanka, Argentina and others have all done so.
Money managers are therefore cautious bond buyers. They look for warning signs such as irresponsible government spending plans or a lack of fiscal discipline. Red flags might include government politicians questioning the need to repay debt, implementing knuckleheaded price controls, or dismissing foreign investors as “speculators” or the “little gnomes of Zurich,” as a British Labour prime minister did in the 1960s. Famously, the “gnomes” had the last laugh in 1976, when the Labour government was forced to seek what was then the largest ever emergency loan from the International Monetary Fund after investors effectively went on strike and refused to fund its spending plans.
For this reason, money managers are often described as “bond market vigilantes”, policing the use of their savers’ money and government spending plans. They are not like a Masonic lodge, with secret handshakes and strange rituals involving trousers, but they do tend to read the same websites, share similar training, and they particularly dislike being called names.
Consequently, they can react quickly to bad news and sometimes move together in herds. This is why the bond market is so powerful: it can act as a brake on governments’ worst spending instincts by pushing up interest rates. James Carville, an adviser to President Clinton, once quipped:
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope… But now I want to come back as the bond market. You can intimidate everybody.”
It is a humorous line, but not entirely a joke. The bond market’s power stems from a simple reality: most governments are permanent borrowers. Unlike a one-off bank loan, their financing needs recur year after year. Worry investors today, and you may pay for it in the form of higher interest rates for many years to come.
These interest rates matter greatly because they ripple through the entire economy. When government borrowing costs rise, the effect passes quickly into bank lending rates, mortgage rates, corporate borrowing costs and, ultimately, employment. What begins in bond markets rarely stays there.
In the end, there is nothing mysterious about the bond market. It is simply the place where politicians meet savers; where optimism meets arithmetic. Governments can promise whatever they like and insist that markets “get in line”. But the bond market sets the price of those promises. Spend freely and credibly, and funding remains cheap. Push too far, and discipline is swift – delivered not with speeches or votes, but with yields. The vigilantes – and the gnomes – will see to that.
Please be aware that the value of investments may go up or down and you may receive back less than you invested originally. Past performance is not a guide to the future.
This document contains general information only and does not provide any advice or guidance specific to your personal circumstances.
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