By Lawrence Delevingne, Yoruk Bahceli, Davide Barbuscia and Dhara Ranasinghe
NEW YORK/LONDON (Reuters) – When Bill Clinton began his first term as president in 1993, he faced a challenge to his authority from an unexpected adversary: bond traders. Low taxes and high defense spending over the prior decade had contributed to U.S. debt doubling as a share of economic output.
Clinton and his advisers worried that ‘bond vigilantes’ – so called because they punish governments’ profligacy – would target the new Democratic administration. A run on U.S. Treasury bonds, they feared, could sharply raise borrowing costs, hurting growth and jeopardizing financial stability. A frustrated Clinton was forced to make the unpopular decision to raise taxes and cut spending to balance the budget.
“He went away pretty disgusted with the idea that here he had just won an election by a pretty nice margin in a difficult three-way race, and now he was subservient to a bunch of bond traders,” said Alan Blinder, one of Clinton’s closest economic counselors who later served as the vice chair of the Federal Reserve. “A lot of us are wondering if the bond market vigilantes are going to come back for a second chapter.”
As Donald Trump takes office on January 20, concerns over bond vigilantes in the United States have resurfaced, according to several market experts. And this time, the economic indicators are even more alarming, they said.
The U.S. debt-to-GDP ratio is pushing 100%, double the level in Clinton’s time. Left unchecked, by 2027 it’s projected to exceed the records set after World War II, when the government borrowed heavily to fund the war effort.
Bond yields, which move inversely to prices, have been climbing. The yield on 10-year U.S. Treasury bonds has risen more than a percentage point from a September low, a whopping increase for a measure where even hundredths of a percent matter.
Like Clinton before him, Trump now faces the prospect of bond vigilantes becoming a potent check on his policy agenda, according to several former U.S. and foreign policymakers who faced market turmoil while in office.
Reuters interviewed nearly two dozen policymakers, economists and investors – including Trump advisers, a former Italian prime minister and former Greek and British finance ministers – and examined bouts of bond market routs around the world since the 1980s to assess the risk of turbulence after Trump takes office.
The review found several indicators watched by bond traders are flashing red. U.S. federal debt has increased to more than $28 trillion, from less than $20 trillion when Trump took office in 2017. Debt is also piling up in other countries, with the world’s total public debt expected to cross $100 trillion for the first time in 2024, leaving investors nervous.
“There’s a risk of the bond vigilantes stepping up,” said Matt Eagan, portfolio manager at Loomis (LON:0JYZ) Sayles, a fund manager with $389 billion under management. “The unanswerable question is when that would occur.”
The experts believe Trump has some cover, thanks to the dollar’s status as the global reserve currency and the Fed’s now well-established ability to intervene in markets in moments of crises, which means there are always buyers of U.S. debt.
Other nations may be at more imminent risk, partly because of worries that Trump’s trade policies would dampen their growth, the experts said. Some of Europe’s biggest economies, including Britain and France, have come under pressure in bond markets recently.
The Reuters analysis of past crises showed it’s hard to predict what will spark a bond market selloff. Part of the problem is market signals are open to interpretation. But once panic sets in, conditions can quickly spiral out of control, often requiring sizable intervention to re-establish stability.
Robert Rubin, Clinton’s Treasury Secretary and a former co-chairman of Goldman Sachs, said the bond market “could very quickly make it very difficult” for Trump to do what he wants if a steep rise in interest rates triggered a recession or financial crisis. “Unsound conditions can continue for a long time until they correct, rapidly and savagely. When the tipping point might come, I have no idea,” he said.
Trump has said he wants to lower taxes and stimulate economic growth, but many of the policymakers, economists and investors who spoke to Reuters viewed with skepticism his promises for draconian cuts to government spending and pay for his plan with trade tariffs.
Combined with worries that Trump might weaken U.S. institutions like the Fed, these people said, the Republican’s policies could provoke a violent market reaction that would force him to reverse course. Stephen Moore, a longtime Trump economic adviser, singled out the risk of “massive tariffs” that could harm global growth as one possible trigger.
Anna Kelly, a spokesperson for Trump’s transition team, said in a statement: “The American people re-elected President Trump by a resounding margin, giving him a mandate to implement the promises he made on the campaign trail, and he will deliver by ushering in a new Golden Age of American Success on day one.”
She did not answer specific questions about current bond market conditions and the risk of a flare-up from Trump’s plans.
BETTING ON TAX CUTS
Economist Ed Yardeni, who coined the term bond vigilantes, said Trump had bought some time by promising to cut spending and naming market-savvy people to his team such as his Treasury Secretary pick, Scott Bessent, a long-time hedge fund manager familiar with debt markets.
Such people could play the same role that Rubin did for Clinton, Yardeni said, “in making him realize that whatever he does, it’s got to come out as relatively fiscally conservative on balance.”
Bessent said in June he’d urge Trump to slash the federal deficit to 3% of economic output by the end of his term, from 6.4% last year. In prepared testimony for his confirmation hearing in Congress on Thursday, he praised Trump’s 2017 tax cuts and his tariff plans, and said Washington must ensure the dollar remained the world’s reserve currency.
He didn’t respond to requests for comment on the bond market.
However, another long-time economic adviser to Trump, the economist Arthur Laffer, said the budget deficit is not the right focus. His Laffer Curve theory, dating back to the 1970s, posits that tax cuts can actually lead to higher tax revenues by stimulating economic activity.
Laffer said the recent rise in bond yields was a positive sign for the new administration: it reflected bets that Trump’s policies would boost growth.
“They’re going to borrow the funds they need to borrow to increase the productivity of goods and services in the U.S. economy and encourage work, effort and productivity, and participation rates,” Laffer said. “That’s what we did under Reagan, and that’s what Trump [will do] right now.”
Laffer was an economic adviser to former President Ronald Reagan, whose tax cuts and higher spending in the 1980s caused deficits to balloon – policies that Clinton had to reverse.
Bill Gross, a prominent bond investor who was in the vigilante posse that faced down Clinton, dismissed Laffer’s prediction that growth would resolve the substantial U.S. deficit.
“Didn’t happen. Won’t happen now,” Gross said in an email.
“ATMOSPHERE OF CHAOS”
Reuters’ review of bond vigilantism since the 1980s showed that once markets stop having confidence in policy, politicians can quickly lose control.
Alarm (NASDAQ:ALRM) over unfunded tax cuts in the UK budget – meant to spur economic growth – roiled Britain’s debt markets in the fall of 2022. Gilts suffered their biggest one-day rout in decades and the pound sank to record lows, forcing the Bank of England to intervene.
“My main recollection was the atmosphere of chaos,” said then-finance minister Kwasi Kwarteng, who was fired by his boss, prime minister Liz Truss, after only 38 days in his job.
“The market essentially forced the prime minister to remove me, and also as a consequence of that, I mean she just couldn’t hold the line, and she resigned literally six days later,” Kwarteng said.
Truss, the shortest serving prime minister in British history, did not respond to an interview request. She has defended her budget, saying she tried to implement the right policies.
Traders’ decisions to buy or sell debt reflect a range of factors such as what they think of a country’s growth prospects, inflation trajectory and the supply and demand for bonds.
Some metrics are now suggesting that lending money over a longer period is getting riskier, prompting investors to charge more interest on bonds.
One such metric is how a country’s borrowing costs compare to its growth potential. If they are higher than growth in the long term, the debt-to-GDP ratio would increase even without new borrowing, meaning it risks becoming unsustainable over time.
The Fed sees long-term U.S. real growth at 1.8%, which translates to 3.8% in nominal terms once the central bank’s inflation target of 2% is taken into account. The U.S. 10-year bond yields are already higher, at around 4.7% currently. If that continues, it would suggest the current growth trajectory will not be enough to sustain the debt levels.
The story is similar in Europe. For example, Britain’s budget watchdog estimates real growth averaging 1.75% in the long term, which including a 2% inflation target would lag the 10-year gilt yield of around 4.7%.
US POLICY, GLOBAL IMPACT
Much rides on how bond markets respond to the Trump administration. A surge in interest rates in the United States – the world’s biggest economy and the lynchpin of the global financial system – would send shockwaves globally.
Sovereign debt markets are already jittery. In recent days, the UK has come under pressure from bond traders who at one point pushed the yield on 30-year British government bonds to a 26-year high. The additional yield France pays for 10-year debt over Germany rose in November to the highest since 2012 when Europe was engulfed in a sovereign debt crisis.
Higher borrowing costs for governments trickle down to consumers and companies, curtailing economic growth, increasing debt defaults and leading to sell offs in stock markets.
Regaining the confidence of bond markets can require painful steps that hit Main Street – such the series of austerity measures that Greece had to implement, starting in 2010, to stem the European sovereign debt crisis.
Mario Monti, an economist who was tapped in 2011 as prime minister to rescue Italy from financial implosion, said a major difference now is that the largest European economies are under pressure, whereas in the past it was the smaller ones.
Monti said the leadership of the United States, under then-President Barack Obama, was vital to help contain the euro zone crisis.
In May 2012, Obama held a two-hour meeting with Monti, and his German and French counterparts at Camp David, in Maryland, during a G8 gathering. “Curiosity and pressure from Obama was extremely helpful,” Monti said.
TRIGGER POINTS
Economists disagree over to what extent higher U.S. bond yields are currently being driven by factors like growth and inflation expectations, versus the demand and supply of new bonds, or the sustainability of government debt.
Moore, the Trump adviser, attributed the rise in yields to investors getting nervous about inflation creeping up. He blamed that on the Fed’s move to cut rates at the end of last year: he said that had sent a message to the market that the central bank was not serious about bringing inflation down to its 2% target.
Fed officials have repeatedly said they want to hit that objective.
Moore said that some investors’ worries about government spending were weighing on yields, too, and that it was unclear how effective the Elon Musk-led Department of Government Efficiency would be. “There’s some concern about whether Republicans are serious about cutting spending,” Moore said.
Musk has acknowledged that his goal of cutting $2 trillion in spending from the $6.2 trillion federal budget is a long shot.
Bond markets are waiting to see the impact of Trump’s spending cuts and tax reductions, and disappointments could trigger the vigilantes, several experts said. Persistent wrangling over the U.S. debt ceiling, further downgrades to the U.S. credit rating or a fall in foreign demand for U.S. Treasuries due to reasons like sanctions and wars could make matters worse.
“There are many possible sparks,” said Ray Dalio, the founder of macro hedge fund firm Bridgewater Associates, in an email.