As an abused victim of natural gas markets, I can claim firsthand knowledge of the wild impact of gas market traders. What puts them into Lambos and ski chalets is volatility, and they will, hmm, help along, one could say, the wildest gyrations possible in that pursuit. Ten cent gas today, ten dollars next week. Then back again. That’s their dream. Chaos be damned. Thanks for the “liquidity”. You’re the best.
It happens in stock markets as well. A company that the market suspects will need to raise equity is like a lonely deer dipped in bacon grease and sent out into a wolf den. A new equity issue will have to be priced slightly below market to get people to buy, so savvy market participants know a company that has to issue stock will see downward pressure on its share prices, and that means a trading opportunity. Markets will punish the stock mercilessly because the odds of making money have tilted in traders’ favour. Hello Ferrari.com.
Both those examples are not really good or bad per se, but could be either depending on which seat you’re in. These actions are a function of markets making ‘price discovery’, which is over time a good thing, even if sometimes you’d like to strangle the participants and/or take a sledge hammer to their $500k automotive trophies.
Sometimes though, and far more frightening for humanity, is that similar players play similar games in debt markets. It is an important function to occur, because sometimes their actions are the only way to get governments to pay attention. But to be very clear, the trading activity in debt markets is far more than a game however, because the actions have truly huge consequences, for everyone.
The US is in debt up to its eyeballs, and the total is growing rapidly. That means the US is forced to borrow more and more money, every week. Currently, the US national debt is increasing by about $1 trillion every 100 days. That means every 100 days, the government has to pay billions more in interest payments than it did the previous 100 days, unless interest rates are cut (more on that in a bit).
About three months after one gets their first credit card, they can see that this modus operandi does not end well. You can’t just keep borrowing. In fact, once a certain debt level is reached, it is crippling to live with even without increased borrowing, because interest payments eat up so much of disposable income.
But governments, the US in particular, has a helping hand that you don’t – an influence on interest rates. While in mechanical terms the Fed sets interest rates independent of the government, government policies determine how much the government will hit up lenders for.
Currently the US is flirting with extreme danger. Total interest payments on federal debt now exceed the government’s defense budget.
That’s where trading monkeys come to life, and start trashing the room. Ever heard of a bond vigilante? Here’s a reasonable definition from Investopedia: A bond vigilante is “a Bond trader who threatens to sell, or actually sells, a large amount of bonds to protest or signal distaste with policies of the issuer. Selling bonds depresses their prices, pushing interest rates up and making it more costly for the issuer to borrow.”
Another way to look at is that bond investors, which are lenders, decide that they are not going to buy any more bonds (loan any more money) because they think the borrower’s credit stinks. In effect.
Understanding bond vigilantes is an important step in understanding the conundrum that the US government is now in. It wants interest rates to be lower for political reasons, because lower interest rates are better for borrowers of all types, whether they are borrowing for autos or homes or businesses or lines of credit for whatever.
The federal government also desperately wants interest rates to be lower for survival reasons, because it literally cannot afford to pay the interest on such massive debt. And both parties in the US election are making promises that are, at least in the short term (next few years) going to drive up debt levels (there is no way to stop the borrowing frenzy in the short term; commitments are simply too high, and any new policy aimed at growing a sector or sectors of the economy is going to take time to have an impact).
In this instance, the bond vigilantes aren’t simply looking to whipsaw the market to make money, although there will be some of that – that’s the very nature of short sellers, ‘investors’ that ‘borrow’ something and sell it in hopes of driving down the price so they can buy it back cheaper down the road. In this example, they will dump US government debt, driving down the price and driving up interest rates. Which the government cannot allow – it needs cheaper debt, not more expensive.
The government is in a real bind; if interest rates and borrowing costs go up, they will have no choice but to take an axe to spending, and no one is going to like that because they will have to hit sacrosanct programs – defense, social programs, mass layoffs, etc. No politician will want to do that, which is why we see them continuing to spend beyond their means even as the debt alarm bells are deafening.
We watch people at the lower end of the socioeconomic spectrum spend themselves into trouble, buying shiny cars they can’t afford, taking holidays they shouldn’t, and abusing credit and credit cards with no apparent view of what is going to happen to them (and their credit scores) down the road. We look down on them and shake our heads in sadness or scorn at their miserable situation and poor money management.
But then we elect people to run countries and economies, including the most powerful economy on earth, that do the exact same thing. (Well, there’s one difference: the politicians don’t really have skin in the game, and their pay stub will be pretty impressive no matter how much chaos they create. The problem will be everyone else’s. They might get thrown out of office, but the pensions are pretty sweet, as are the forthcoming consulting gigs.)
The story is as old as money itself: Don’t spend more than you earn or can afford. Save for a rainy day.
Too bad governments didn’t listen. Governments of all stripes. “Fiscally prudent” governments of the past few decades have run up debt almost as bad as the ones that don’t seem to care much about finances at all.
This scenario painting is a gross oversimplification because there are so many variables at play, for example, a large move up or down for the US dollar relative to other currencies can help solve (or exacerbate) some of these problems, depending on the rate of inflation, US import/export balances, other nations’ debt levels, etc. So there won’t be any immediate earthquake of consequences because some of these variables will shift as the market buys or sells various components. But the fact remains: governments cannot indefinitely increase borrowing levels, because that increases interest payments, which governments cannot afford to avoid. The only new mechanism that can be helpful is the bizarre circumstance of a few years ago of negative interest rates, where people actually paid to loan money to governments. But that clearly isn’t any sort of stable mechanism, and is indicative of a system wildly out of whack, so not something to wish for.
The atmosphere next week is going to be electrifying, no matter who wins. A good third of the population is guaranteed to be either apoplectic or terrified, without a doubt. The emotions are going to be as intense as the sun, because each side has pitched this election as a ‘fight to save democracy’.
It will mostly be theatre – except for what happens in the bond markets. That is what we all need to worry about, because the consequences are going to be immense.
Terry Etam is a columnist with the BOE Report, a leading energy industry newsletter based in Calgary. He is the author of The End of Fossil Fuel Insanity. You can watch his Policy on the Frontier session from May 5, 2022 here.
