In the mid-1980s, noted economist Edward Yardeni coined the name “Bond Vigilantes” for aggressive bond market sellers who drove interest rates higher whenever they determined government spending was irresponsible. In fact, they were among the factors blamed for the “Bond Crisis” of 1994, when U.S. bond markets lost a trillion dollars in value.

Inflationary expectations, deteriorating credit quality, and surprise Fed hawkishness created a market environment ripe for a crisis. Could that be the situation today?

Is that why, despite deteriorating housing and labor markets and a dovish Fed, two-year Treasury yields just traded above 4 percent, and 30-year Treasury yields went above 5 percent? 

Certainly, inflationary expectations have increased due to the surge in oil prices caused by the Iran conflict. Despite an alleged ceasefire, fighting rages on in the Middle East, and the Strait of Hormuz remains barricaded. Oil is central to all economic production, so its increase cannot help but increase the overall costs in an economy.

While the official story surrounding oil is that its price increase is only temporary, that is not what key members of the Fed all believe. Last month’s Fed decision to keep rates steady was met with four dissenters on the Fed Open Market Committee (FOMC). Such dissent has never happened before. One was the Super Dove, Stephen Miran, who voted for a rate decrease. But the other three all voted to change the Fed stance from dovish to hawkish, with the next round of Fed moves to bring rate increases. For now, they were outvoted.

In 1994, however, it was surprise Fed rate hikes that triggered the bond market crash. The Fed maintained a dovish bias and lowered rates consistently for nearly 6 years. The yield curve protested the policy, steepening to over 450 basis points. Credit spreads narrowed to unprecedented levels. Leverage was the order of the day as Wall Street borrowed money at 3 percent to buy bonds at 7.5 percent. When the Fed unexpectedly began raising borrowing costs, that trade unraveled.

Today, the situation is eerily similar. Moreover, the U.S. debt load has become massive. For the first time since World War II (except during the pandemic), the U.S. national debt has surpassed the country’s GDP. According to CBS News, the U.S. is now spending more to service the debt than to fund national defense or Medicare. Credit downgrades are sure to follow. The market must be paid for this growing supply and credit risk.

Will the Bond Vigilantes ride again?