Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / The Bond Vigilantes Are Back and the Fed Is Cornered
Transcript
- Lucas: So there's a phrase that's been showing up in market commentary more and more — 'bond vigilantes'. It sounds dramatic, but the concept is actually pretty straightforward. Bond vigilantes are investors who sell government bonds — or threaten to sell them — to punish what they see as irresponsible fiscal or monetary policy. And right now, with inflation still running hot and a new Fed chair about to take office, a lot of people think the vigilantes are waking up. Luna: And this isn't just some abstract theory. We saw a taste of it earlier this month when the ten-year Treasury yield spiked after that hotter than expected CPI print for April. Lucas: Exactly. CPI came in at 332.4 for April — that's up from 330.29 in March. The core index, which strips out food and energy, also ticked higher. And the market reaction was immediate: the ten-year yield jumped, and the breakeven inflation rate — which is basically the market's expectation for average inflation over the next decade — moved up. It's at 2.44 percent as of yesterday, down a bit from recent highs, but still elevated. Luna: And this is happening as we're about to get a new Fed chair. Kevin Warsh is being sworn in on Friday. So the timing is, let's say, interesting. Lucas: It's a real test. Warsh inherits a situation where the Fed has been cutting rates — or at least holding them steady — while inflation refuses to drop below 3 percent. The real federal funds rate is still negative if you look at core PCE, which was at 129.3 in March. And the labor market is showing some cracks: initial jobless claims ticked up to 211,000 for the week ending May 9, from 199,000 the prior week. That's not a huge move, but it's a direction you don't want to see when inflation is sticky. Luna: So the vigilante narrative is that the Fed is behind the curve, and if they don't hike rates soon, the bond market will do the tightening for them — by pushing yields higher, which effectively tightens financial conditions. Lucas: Right. And there's a historical parallel here. In the late 1970s, bond investors got burned by inflation eroding their returns. So they started demanding higher yields, which forced the Fed under Paul Volcker to raise rates dramatically. The vigilante label actually comes from Ed Yardeni, who coined it in the 1980s. And Yardeni has been saying recently that the Fed will have to raise rates in July to appease the vigilantes. Luna: That's a pretty specific call. And it's not just Yardeni — traders are now pricing in a higher probability of a hike at the July FOMC meeting, after the April CPI data. Lucas: Exactly. The market is basically daring the Fed to keep rates where they are. If Warsh comes in and signals a dovish stance, you could see a sell-off in bonds that pushes the ten-year yield well above 4.5 percent. That would have knock-on effects for mortgage rates, corporate borrowing costs, and equity valuations. Luna: And it's not just about the Fed. There's also a fiscal dimension. The government is running a large deficit — nominal GDP is over $31 trillion, but the debt to gdp ratio is high. If bond yields rise, the cost of servicing that debt goes up, which puts pressure on Congress to cut spending or raise taxes. Lucas: That's the key point. Bond vigilantes don't just target the Fed — they target fiscal policy too. If investors think the government is on an unsustainable path, they'll sell bonds, pushing yields up, which makes it harder for the government to borrow. That's a form of market discipline that we haven't really seen in the U.S. since the 1990s, because the Fed was buying so many bonds through quantitative easing. Luna: Now the Fed is shrinking its balance sheet — quantitative tightening — so there's less of a buyer of last resort. The private sector has to absorb all that new issuance. Lucas: And that's exactly the environment where vigilantes can have more impact. If you look at the ten-year breakeven inflation rate — which is the difference between nominal yields and TIPS yields — it's been hovering around 2.4 percent. That's not panic levels, but it's above the Fed's 2 percent target. And if it breaks higher, that's a signal that the market doesn't believe the Fed can get inflation under control without a recession. Luna: And we're already seeing some recession indicators. The yield curve has been inverted for a while. But the job market is still adding jobs — nonfarm payrolls were at 158.7 million in April, up from 158.6 million. So it's a mixed picture. Lucas: Right. That's the stagflationary flavor. Growth is slowing — real GDP growth annualized was only 2 percent in Q1, up from a meager 0.5 percent in Q4 2025, but that's still below trend. And inflation is above 3 percent. So we have slow growth and high inflation. That's the classic setup for bond vigilantes to get active. Luna: Before we go further, I want to pause and mention something. If you find these conversations useful and you want to keep them ad-free and freely accessible, listener support is what makes that possible. There's a page — buy me a coffee dot com slash fexingo — where a few dollars a month goes a long way. Just putting that out there. Lucas: Yeah, absolutely. And it's because of that support that we can spend time on topics like this without any sponsor pressure. So thanks to those who chip in. Now, back to the vigilantes. Lucas: So let's talk about what a bond vigilante episode might actually look like. It's not a single event — it's a process. A few big asset managers decide they're overweight Treasuries and start reducing their positions. That pushes yields up a bit. Then other managers see that and follow suit, because they don't want to be the last one holding bonds that are losing value. The selling can snowball. Luna: And it's not just domestic investors. Foreign holders of U.S. debt — like Japan and China — could also reduce their holdings if they see the U.S. fiscal situation deteriorating. Lucas: That's a risk. China has been gradually reducing its Treasury holdings for years. And if geopolitical tensions — like the Iran situation and the Russia-Ukraine situation — lead to more sanctions, some countries might want to diversify away from dollar assets. That would add to the selling pressure. Luna: So what can the Fed actually do to prevent a vigilante revolt? Lucas: The standard answer is to raise rates. If the Fed shows it's serious about fighting inflation, it restores credibility, and bond investors don't need to demand as much of a risk premium. But the problem is that raising rates could slow the economy even further, and the Fed doesn't have a lot of room. The federal funds rate is still well below the inflation rate in real terms. Luna: And Warsh has to balance that with the fact that the labor market is starting to cool. Initial jobless claims rose above 200,000 — that's a modest increase, but it's a change in trend. Lucas: Yes. And the JOLTS data shows job openings fell to 6.866 million in March, down from 6.922 million in February. That's a decline. So the labor market is loosening, but wages are still rising — average hourly earnings were up to $37.40 in April from $37.35. That's good for workers, but it adds to cost pressures for businesses. Luna: So the Fed is stuck: if they hike, they risk a deeper slowdown; if they hold, they risk inflation expectations becoming unanchored and a bond sell-off. Lucas: That's exactly the corner they're in. And the bond market knows it. That's why the ten-year yield has been volatile. It's not just about the next CPI print — it's about the fiscal trajectory, the Fed's credibility, and the global demand for U.S. debt. Luna: One thing that could help is if the government actually shows some fiscal restraint. But with an election coming up and spending pressures from defense and entitlements, that seems unlikely. Lucas: Right. And that's exactly what vigilantes are waiting for — a signal that policymakers are serious about the deficit. If they don't get it, they'll act. The question is whether this time is different from the 1970s, when it took a recession and double-digit rates to break the back of inflation. Luna: Are we at that point yet? Or are we just in the early stages of a vigilante awakening? Lucas: I'd say we're in the early stages. The breakeven inflation rate is elevated but not screaming. The yield curve is inverted, which usually predicts a recession, but the economy is still growing. So the vigilantes are testing the waters. They want to see what Warsh does in his first few months. If he comes out hawkish, they might back off. If he's dovish, they'll push yields higher. Luna: Either way, the era of free money is over. And that's a big adjustment for markets and for the government. Lucas: Absolutely. For the last fifteen years, the Fed was a constant buyer of bonds, suppressing yields. Now it's not. The vigilantes are filling that void, and they have a much shorter patience for inflation. That's the new reality. Luna: So what should the average investor do? Or is it just a wait and see game? Lucas: I think the key takeaway is to be aware that bonds are no longer a safe haven in the same way. If inflation stays sticky, bonds can lose value. Diversification into real assets, commodities, or even short-duration bonds might make sense. But it's really about watching the ten-year yield and the breakeven rate as leading indicators. Luna: And maybe keeping an eye on gold. It's been selling off recently — down 2.3 percent over the last five days — but that could change if the vigilantes push yields higher and create real economic stress. Lucas: Gold is interesting. It's often a hedge against both inflation and financial instability. But it competes with bonds: if real yields rise, gold becomes less attractive because it doesn't pay income. So the vigilante dynamic is actually a mixed signal for gold. Luna: Right. So the bottom line is: the bond market is sending a message. And the Fed and the government need to listen. Lucas: Exactly. And we'll be watching to see how Kevin Warsh handles that message when he takes office on Friday. Thanks for listening, everyone.