Key Takeaways
- The 70s and 80s saw bond investors act as authorities lost control of inflation and budget deficits. Wall Street economist Ed Yardeni coined the phrase bond vigilantes.
- Inflation is lower today, but deficits are high. In the US, government debt is on track to exceed 100% of GDP this year. The new administration has plans to cut spending – it will be interesting to see how much progress they can make.
- Rising gilt yields in the UK have put Chancellor Reeves under pressure and all of this is taking place against a backdrop of weak confidence. The near term looks challenging for the UK and some difficult decisions lie ahead.
- We expect US inflation to edge down this year and some progress made in cutting the US deficit could be made. This would lead to lower Treasury yields and in turn help risk assets rally.
Many analysts of my age are thinking back to the 1970s and 1980s when the US authorities lost control of both inflation and the budget deficit. Bond yields soared, the US economy fell into recession and inflation and interest rates tumbled. Or so the narrative goes. Ed Yardeni, a leading Wall Street economist then and now, coined the phrase, bond market vigilantes, who took matters into their own hands when the proper authorities were not keeping order. It was a similar story in the UK with the added complication of a sterling crisis.
Well, the bond market vigilantes are back. Inflation is a lot lower today, but budget deficits are higher, not just in the US but around the world. At 6.3% of GDP, the US budget deficit now exceeds any of the numbers in the 70s and 80s – even in recession years. Given the strength of the US economy, it should be much lower. US government debt is rising rapidly and is set to exceed 100% of GDP this year up from 30% in 2010. The new administration has ambitious plans to cut spending with a brand-new Department of Government Efficiency, headed up by Elon Musk. I stand ready to be surprised by the scale of his success but I’m sceptical for now. Incoming President Trump has a tax cutting agenda and markets do not like his plans for big increases in tariffs. Rising bond yields have hit equities despite good earnings.
The UK has been especially hard hit and rising gilt yields have torpedoed Chancellor Reeves’ fiscal rules – corporate and business confidence is weak. Now anyone who follows bond markets will know that around 75% of the ups and downs of UK gilts are determined by the US bond market. As a result, we are caught in the crossfire of the bond market vigilantes. But the other 25% is our responsibility and here decisions by the incoming government to permit big increases in minimum wages, public sector wages and hiking National Insurance costs have made it all a lot worse.
So where will it all end? When it comes to the US, we think inflation will continue to edge down over the course of 2025 despite the strength of the US economy. We also think – but with rather less confidence – that they incoming US administration will cut the budget deficit. That should lead to lower Treasury yields. As for the UK, the next few months will be especially challenging. Companies will be raising prices and cutting headcount ahead of the big increases in wage costs due in April. Demand might be firm as workers spend their above inflation wage awards and home buyers rush to transact before stamp duty goes up. The markets expect the Bank of England to cut the Bank Rate when they meet next month. I think they should keep rates on hold. Moreover, the Office for Budget Responsibility’s report in March is likely to show borrowing is above the government’s fiscal limits raising fears of more tax increases and the need for politically difficult spending decisions. It’s not all bad. Those generous public sector pay awards have ended most of the strikes, at least for now. The construction sector looks buoyant, housebuilding excluded. If and when yields do fall in the US, the UK will follow suit. The bond market vigilantes can go back into retirement and risk assets can rally again.
