Penn Mutual Asset Management CIO Mark Heppenstall contributed an article to The Hill where he discusses the rise of “stock vigilantes” - investors who redirected Federal Reserve (Fed) policy amid continued monetary tightening in 2018. As Fed interest rate hikes slow and U.S. economic growth moderates, Mark explains what factors pose the greatest risk to markets in 2019. The post originally appeared on The Hill on 1/24/2019 and can be found below.
In the midst of an early 1980s inflationary environment, which was quite the opposite of today, noted economist Edward Yardeni coined the term bond vigilantes. This describes fixed income investors with the power to enforce monetary discipline on policymakers to fight inflation. By selling bonds and setting interest rates higher, they could effectively assume the role of the Federal Reserve to raise borrowing costs and tighten credit.
Inflation in the United States started to soar in the late 1970s, after the consumer price index increased by double digits three years in a row. The response of the Federal Reserve under Paul Volcker was fast and furious, with short term interest rates nearing 20 percent. The economy soon went into a recession and the unemployment rate was next to soar into double digits. Fears of a repeat of the great inflation era remained on the minds of investors for more than a decade. The Clinton administration was the last victim of intimidation by bond vigilantes in 1994, when long term interest rates touched 8 percent. As a result, a federal spending initiative was abandoned at the urging of soon to be Treasury Secretary Robert Rubin.
Since then, deflation rather than inflation has become the bigger threat to economic prosperity in the United States and Europe. Central bankers everywhere fear a repeat of the decades long deflationary spiral in Japan. The 2008 financial crisis prompted new measures to fight deflation, including quantitative easing and negative interest rate policies. Saint Louis Federal Reserve Bank President James Bullard offered a defense of unprecedented easy money policies in a 2010 paper. Despite a concerted effort of accommodation among global central bankers, inflation rates remain stubbornly below the universal 2 percent target.
Just when it appeared bond vigilantes may never come out of hibernation, Donald Trump won the 2016 presidential election. His passage of new fiscal stimulus measures focused on growth gave bond vigilantes new life. Yardeni himself suggested they were “saddled up and riding high.” Long term interest rates moved higher through most of 2018 and the 10 year Treasury broke through the important 3 percent barrier in September. As bond vigilantes seemed back in control, stock market investors decided to take back the reins and point the Federal Reserve in a new direction.
The Federal Reserve has a long history of responding to extreme stock market declines dating back to the 1929 market crash. However, policy responses have become increasingly sensitive to any level of market stress after the 2008 financial crisis. The bull market kept taking comfort in the idea that the Federal Reserve would lean toward easier money to ensure financial stability and support the markets in times of need. The “Alan Greenspan put was followed by the “Ben Bernanke put” and then the “Janet Yellen put.” A “Jerome Powell put” is a little more uncertain.
After hiking interest rates in each of his first three quarters as chairman and then suggesting in October that the Federal Reserve was still not close to neutral, stock markets started to tremble under Powell. Hopes faded with another increase at the Federal Open Market Committee meeting in December, followed by a not very soothing press conference. However, as the rout deepened and sent the stock market into bear market territory, Powell turned on a dime and markets did likewise. An unexpectedly strong employment report could not change the newly flexible talk from Powell, marking another victory for stock vigilantes.
I expect the upcoming pause in Federal Reserve interest rate increases will mark the beginning of the end for the current monetary tightening cycle as economic growth and inflation moderate but do not tip into recession. The focus will shift across the pond as the biggest risk in 2019. Contagions from financial market volatility abroad, as well as European economies on the decline, will leave the European Central Bank with fewer and fewer options to do whatever it takes to calm the markets.