When the government borrows at an unsustainable rate, sometimes it isn’t new faces in Congress that force a return to fiscal discipline, but “vigilantes” in the bond market. Investment banks, hedge funds, insurers, and other large investors will look to drive up government borrowing costs by selling their holdings of Treasuries, thereby increasing the interest rate that the federal government has to pay to service its debts.
Ed Yardeni—an economist who spent decades on Wall Street at firms like Deutsche Bank and Prudential and now runs his own financial consulting firm, Yardeni Research—coined the term “bond vigilantes” in 1983 to describe these market-moving investors.
In a July 1983 paper titled “Bond Investors Are the Economy’s Bond Vigilantes,” he explained: “[I]f the fiscal and monetary authorities won’t regulate the economy, the bond investors will.”
Now, with the U.S.’s national debt and deficit both at historic highs, Yardeni believes bond vigilantes are once again out in force. And they have a new leader—the billionaire hedge funder Bill Ackman.
“Barron's declared today that Ackman is the new Bond King. We think he is actually the King of the Bond Vigilantes,” Yardeni said in a Monday note to clients.
Ackman’s ‘brillant trade’
At the start of August, Ackman, who runs Pershing Square Capital Management, made a very public bet against 30-year Treasuries. He argued that rising federal deficits and gridlock in Washington, as well as “structural changes” to the global economy—including deglobalization, the green-energy transition, and increased worker bargaining power—would lead to an era of higher inflation and fiscal instability. And inflation and fiscal instability mean investors should require more compensation—in the form of higher yields—for the increased risks of holding U.S. debt.
To Ackman’s point, new data from the Treasury Department shows the national deficit rose almost 25% year over year to $1.7 trillion for the fiscal year 2023, which ended September 30. And increased spending has pushed the national debt up over $10 trillion in the past decade— from $22 trillion in 2013 to well over $33 trillion today.
That wasn’t so bad when interest rates were low, but now that bond vigilantes are out in force and the Fed has raised rates sharply to counter inflation, carrying a deficit is becoming costly. The interest expense on the national debt has soared 67% since the pandemic began, from $544 billion per quarter at the start of 2020 to $909 billion per quarter this summer.
Ackman first publicized his big bond short on Aug. 2 in a post on X, formerly Twitter, just a day after Fitch Ratings downgraded U.S. Treasuries’ credit rating from AAA to AA+. Between Aug. 2 and Oct. 23, when Ackman revealed he exited his short position due to a “slowing” economy and geopolitical risks, the 30-year bond yield soared from 4.11% to over 5%.
When bond yields rise, bond prices fall—so this is a sign that his trade was profitable. “It was a brilliant trade,” Yardeni said of Ackman’s big short.
While it’s difficult to fully measure the impact that bond vigilantes are having on Treasury yields, the Fed does track the so-called “term premium” for the 10-year Treasury. The term premium measures the “extra” yield that investors require in order to hold longer-term Treasury bonds, instead of short-term notes or bills. The premium required was negative for many years when interest rates were held low in the mid-2010s, but in recent years it has risen, in a sign that vigilantes may be finally awakening again. Since its COVID-19 low, the term premium has soared from -0.9%, to over 0.37%.
Ackman and other big investors may be pushing for more fiscal responsibility by betting against Treasuries, but it’s a dangerous time to be a bond vigilante. If the economy begins to struggle or the long-predicted recession rears its head, that could lead the Fed to cut interest rates. This would cause long-term Treasury yields to fall, which, in turn, would lead long-term Treasury bond prices to rise. That wouldn’t be great news for the vigilantes betting against these Treasury bonds—and the danger could prevent them from running rampant, for now.
When Ackman exited his bet against Treasuries on Monday he argued that geopolitical tensions from the Israel-Hamas and Russia-Ukraine conflicts, along with data that shows the economy is slowing, are significant risks to his bet against bonds.
“We agree with Ackman,” Yardeni wrote. “There is too much outright danger in the current geopolitical environment. That favors risk-off trades over risk-on ones, for now.”
