Trump is on a collision course with the bond vigilantes

New York
CNN
 — 

In early 1993, President Bill Clinton looked to push through the economic stimulus package he had touted on the campaign trail.

But those promises were stopped dead in their tracks by a formidable opponent: the bond market.

Clinton was forced to abandon much of the economic plan and shift focus to fixing the budget rather than risk skyrocketing interest rates that would tank the economy.

That episode demonstrated the power of the bond market to check policies that investors disagree with –– even ones championed by a president emboldened by a political triumph.

Clinton political adviser James Carville famously said at the time: “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

The bond market can be so intimidating that in the 1980s, economist Ed Yardeni dubbed these outraged investors the “bond vigilantes” for their role in preserving law and order in capital markets if government officials won’t.

Now there is a risk of another collision between those bond vigilantes and a newly elected president.

Even before President-elect Donald Trump takes office, the bond market is already flexing its muscles. Yields have surged to uncomfortably high levels due to a fusion of factors that includes concerns about high budget deficits and the risk that Trump’s tariffs, tax cuts and deportations will reignite inflation.

“We are in a déjà vu moment,” Yardeni, president of investment advisory Yardeni Research, told CNN in a phone interview. “Trump didn’t automatically win the vote of the bond vigilantes. He’s got to earn their respect.”

If he doesn’t, the bond market could act as a brake on Trump’s policies. And that would be painful, especially for a president who views the stock market as a real-time barometer of his success.

After Friday’s blockbuster jobs report, the bond market sold off again. That pushed 10-year US Treasury rates closer to the 5% level that many view as a dangerous red line.

The higher rates climb, the more pressure they will put on stocks. After all, if ultra-safe government debt is returning 5%, expensive tech stocks look like less of a sure bet by comparison.

Not only that, a possible bond market selloff would make it more expensive for businesses and consumers to borrow, pushing up rates on mortgages and other debt.

That would undermine Trump’s promise to slash Americans’ cost of living.

Higher Treasury rates, by definition, would also make it more expensive for the federal government to finance its mountain of debt. That’s a problem because interest is already swallowing up a greater chunk of the annual federal budget than defense spending.

“Bond vigilantes haven’t been heard from for quite some time. But they’ve only become more powerful,” said Yardeni, noting that America’s growing debt makes the budget more sensitive to even modest shifts in rates.

And higher rates could force the Federal Reserve’s hand, prompting officials to raise their benchmark short-term rates to prevent the economy from overheating.

“That’s a nightmare on top of a nightmare,” said Yardeni.

It’s important to note that Trump is inheriting a very different economy this time around.

When Trump won in 2016, the economic recovery from the Great Recession was frustratingly mediocre. Interest rates were still extremely low. And central bankers were worried that inflation was too low.

Now, the economy is running hot, with gross domestic product, job growth and inflation all surprising to the upside.

Mainstream economists have warned that the Trump agenda could be inflationary, perhaps very inflationary.

Not only that, but deficits are much higher now.

“Trump 1.0 and Biden boxed the incoming administration in,” Yardeni said, “because the bond market will keep them from being able to run reckless deficit policies.”

Some on Wall Street are worried that if policymakers aren’t careful, the United States could face its own “Liz Truss moment.”

In 2022, bond investors rebelled against the budget proposals from British Prime Minister Liz Truss. It was such a disaster that Truss was forced to step down, becoming the UK’s shortest-serving prime minister.

Scott Bessent, Trump’s nominee for Treasury secretary, is well aware of the bond vigilantes. Bessent, a widely respected investor with deep experience in markets, expressed confidence that Trump can slash the budget deficit.

“Bessent is a prince of those bond vigilantes. Now he’s in the catbird seat as Treasury secretary. He knows how to play chess against those other players in the market,” said Ed Mills, Washington policy analyst at Raymond James.

Questions on deficits and tariffs

But it won’t be easy to slash the deficit, especially because there isn’t much room to cut spending. Much of the federal budget is tied up in paying interest, defense spending and social safety net programs that are politically popular.

Even Elon Musk has walked back his previous promise to slash $2 trillion from the federal budget, a figure that many experts have panned as unrealistic.

There remains significant uncertainty over tariffs, including when they may get imposed, how high they will climb and how long they will be in place.

Tariffs could raise revenue but could also ding growth.

“Tariffs are a double-edged sword. They could raise revenue, but they can be damaging to growth because they elicit retaliation from other countries,” said Ernie Tedeschi, director of economics at the Yale Budget Lab and a former chief economist at the White House Council of Economic Advisers under President Joe Biden.

Another major question is whether Trump will go beyond extending the expiring 2017 tax law by enacting new tax cuts.

On the campaign trail, Trump vowed to end taxes on overtime, tips and Social Security benefits and to enact other breaks.

Trump also promised to address complaints about the $10,000 cap on state and local tax (SALT) deductions that were part of the 2017 law. The SALT cap hurt upper-middle-class Americans in high-tax states.

Tedeschi said Republican efforts to lift the SALT cap and enact other tax breaks could provoke a response from bond investors already worried about the deficit.

“Bond traders personally would love lifting the SALT cap. But it would be extremely expensive and worsen our fiscal trajectory,” he said.

Seema Shah, chief global strategist at Principal Asset Management, agreed that investors are concerned about adding to the deficit unless it speeds up longer-term growth.

“You can’t add that much stimulus at this point because inflation is high and the deficit is high,” Shah said.

Yardeni is hopeful the presence of the bond vigilantes, and Trump’s focus on the stock market, will act as powerful vetoes over risky policies, preventing them from becoming a reality.

“If yields spike, the stock market could go down and the administration will respond quickly because Trump views the stock market as his daily popular vote,” Yardeni said. “That’s the power of the bond vigilantes.”