A lot of ink has been spilled on two of the pillars of the Bond Vigilantes Trade: the decline in the US Dollar and the S&P 500.
Yet people tend to forget a true macro Bond Vigilantes trade also requires a third key leg: a spike higher in long-end bond yields.
Basically, the gist of a Bond Vigilantes trade is this.
Bond market investors require fiscal discipline and coherent policies from policymakers.
To force policymakers to comply, they sell long bonds hence injecting risk premium in markets.
This risk premium is then also reflected in a weaker currency and weaker equity markets: cross-asset investors start to require a premium to hold any assets for that specific country.
Financial conditions tighten across the board due to higher yields, a weaker currency and weaker equity markets and this negatively affects the economy. A vicious doom-loop unfolds.
And it’s only when policymakers comply to the requests of Bond Vigilantes with tighter fiscal policy, rate hikes or friendly policymaking that the pressure is relieved and we can go back to normal markets.
Under the hood, The Bond Vigilantes seem to be ready to wake up:
For example, the US Term Premium has recently increased.
The Term Premium is a measure of the compensation investors require for holding long-dated bonds ahead of increased growth and inflation volatility due to erratic policymaking.
As investors could simply choose to deploy their fixed-income exposure by buying and rolling T-Bills and hence avoiding the duration volatility, they require a higher compensation (Term Premium) to get involved with 10-year or 30-year bonds when they perceive volatile macro periods ahead.
The 10-year Term Premium has recently moved from 0% to 0.65% - and while still below the long-term average of 1.50%, this could mean Bond Vigilantes are starting to wake up.
Additionally, the long-end of the bond market is also experiencing ’’plumbing’’ issues.
There are two very popular, heavily leveraged trades in bond markets: swap spreads and basis trades.
Both involve going long the cash Treasury bond, and going short something against it: the basis trades uses the Treasury future as short leg, and the swap spread uses interest rate swaps.
In both cases, the trades involve a large use of leverage because the purchase of the cash Treasury bond is financed using the repo market: for a $100M trade in basis or swap spreads, due to repo market funding hedge funds must only use a tiny portion (~2-5%) of the needed capital to enter the transaction.
Let’s focus on the swap spread trade for a second.
As long as repo markets remain orderly, investors can use it to fund purchases of 30-year US Treasuries, pay a fixed 30-year interest rate swap against it and earn a whopping 90+ (!) bps per year in ‘’swap spreads’’:
But why on earth would investors be able to earn such a premium on US government bonds?
It’s because of regulation and the growing supply/demand imbalance problem in US Treasury markets. Bank regulation has crippled the ability of market makers to warehouse risks, which means their ability to absorb large issuance of Treasuries on their balance sheet has diminished.
On top of it, Treasury departments of US banks are penalized for owning large amount of Treasuries from regulations like the Supplementary Leverage Ratio (SLR) which don’t exempt USTs from its calculations.
Given the supply/demand imbalance, the marginal buyer of US Treasuries tends to be the leveraged hedge fund which gets involved in basis or swap spread trades and demands a hefty premium as compensation. And this fragile system holds until it doesn’t.
As hedge funds get hit by margin calls, they are forced to unwind their leveraged trades and they end up causing more turbulence in the bond market.
Data shows we never truly had a long-lasting, macro-driven Bond Vigilantes episode in the US.
But if you wanted to generate one, you would:
- Have an erratic and aggressive behavior towards your global counterparts (check);
- Risk generating inflation and growth volatility with your (trade) policies (check);
- Do this while your primary budget deficit spending remains very elevated (check);
- Do this while the Fed chair is about to retire, and challenge the Fed independence (check);
- Do this while the bond market plumbing is under some stress (check).
Never like today, being open-minded and creative is an essential skill for macro investors.