Bernard Hickey: Bond vigilantes run the game

New Zealand's bond vigilantes helped push then-finance minister Ruth Richardson to slash benefits in her 'mother of all budgets'. Photo / NZ Herald

A grumbling noise has started within the bowels of the US bond market that everyone who either saves or borrows in New Zealand should know about.

It is the sound of bond vigilantes stirring and telling political leaders to stop spending and borrowing or they will push up interest rates to ruinous levels.

It will mean higher interest rates and restraints on Government spending for all of us, and for a long time.

The phrase "bond vigilante" was coined in the early 1990s, when bond investors started telling US and other governments to spend less money.

Whenever these bond investors worry about debt rising too fast, they push up interest rates by selling these bonds.

They became quite influential because whenever they pushed up long-term bond yields it immediately affected household borrowing through mortgage rates, which were connected to these wholesale markets. They forced politicians to cut benefits and impose new taxes.

New Zealand had its own bond vigilantes. They helped push then-finance minister Ruth Richardson to slash benefits in her "mother of all budgets". She was rightly worried that investors would hike interest rates unless the government showed it could reduce spending.

The bond vigilantes went into abeyance through most of the 2000s because government debt was beaten down to relatively low levels and short-term interest rates were kept (artificially) low by central bank governors such as Alan Greenspan and Ben Bernanke.

They have stayed quiet in the past two to three years as the recession and low inflation drove bond yields lower.

But that era is now over. Governments in Europe and America took on enormous debts from the private sector to avoid complete financial collapse in late 2008 and early last year.

They also spent like drunken sailors on infrastructure and benefits to keep their economies going.

That was fine for a year or two, but now their budget deficits are out of control, over 10 per cent of GDP and public debts are racing towards or are already over the crucial 100 per cent of GDP level.

Once over that threshold, it is difficult to avoid a vicious debt spiral. Low interest rates are crucial once debt is that high. Rising interest rates make such deficits unsustainable and therefore mean the bond vigilantes have real power.

Now those long bond yields are rising. Last week, everything came to a head. The US Government had to sell US$118 billion ($167 billion) worth of bonds in three auctions.

The US Federal Reserve stopped buying mortgage bonds and ratings agencies warned America's AAA credit rating was in danger unless it got its deficits under control.

All this matters for New Zealand because rising US long-term interest rates will slow the world's largest economy. They also set the base for fixed mortgage rates here.

The indebted developed world has begun a long, painful period of deleveraging where growth is slow and new jobs are scarce. Bond vigilantes are back in charge.

* Bernard Hickey is managing editor of interest.co.nz

bernard.hickey@interest.co.nz