Posts Tagged ‘bond vigilantes’

How are bond vigilantes neutered?

Sunday, December 13th, 2009

In our previous article, Rating agencies doing the job of bond markets, we said that bond vigilantes are being neutered. It didn’t occur to us that we had skipped a few steps and some of our readers were wondering why is it so. Our apologies. Here, we will explain why…

First, you have to understand that bond yields and bond prices are inversely related. Why is this so? As we explained in Rating agencies doing the job of bond markets,

For example, if you pay $100 for a newly issued 10-year government bond that pays 6% per annum, you are sacrificing $100 of today?s consumption in order to receive $6 per year for the next 10 years. That 6% is your rate of return on your investment. Now, let?s say you decide to sell your government bond to Tom at $90. The rate of return for Tom is 6/90 = 6.67%. Let?s say Tom sells the bond to Dick at $110, the rate of return for him will be 6/110 = 5.45%. Thus, the rate of return of the bond is inverse to the price paid for it.

What the bond vigilantes do to keep governments accountable is that whenever they perceive governments to be too foolish with their finances (e.g. printing too much money, borrowing too much, etc), they sell off their holdings of government bonds. That in turn will depress the price of government bonds, which imply increases their yields.

The free market is supposed to determine the price of the longer-term government bonds, which implies that long-term interest rates are set by the free market. Therefore, long-term government bond yields are supposed to be an indicator of the trustworthiness of government borrowings. For example, if the free market expects high inflation, then it will be reflected in high bond yields. Conversely, if the free market expects deflation, then it will be reflected in low bond yields.

However, in reality, the price of long-term government bonds are not totally free. Central banks of major nations (e.g. Federal Reserve, Bank of England and Bank of Japan) interfered in the price of long-term government bonds by creating money out of thin air to buy up those bonds. That created additional demand for government bonds, which pushes up its price, which in turn imply lower bond yields than otherwise.

Because central banks is the only authority allowed to create money out of thin air, they can conjured up infinite quantities of money to support bond prices (i.e. “do whatever it takes” to prevent bond prices from falling). Bond vigilantes as a whole do not have infinite resources to push down the yield of bonds. That’s why they are neutered by the central banks.

What happens to the bonds that the central bank purchased? It enters their balance sheet as an ‘asset.’