Era of the vigilante

The era of the vigilante is back.
Hundreds of men wielding golf clubs and other makeshift weapons have been patrolling London in recent days to ward off gangs of rioters – a forceful backlash by local residents who believe their government and police are unable to fully enforce the law.
Similar sentinels are at work in the financial markets. Holders of bonds and bank stocks have been relentless in their pursuit of big-spending governments in Europe. In the United States, equity shareholders, who care mostly about growth, are panicking at the possibility the country is veering into a recession.
They’re exposing holes and forcing change on flailing governments quicker than anyone could have imagined. The big question is: Will they be appeased by lawmakers’ new devotion to creditor interests? Or will it all come crashing down with the realization that politicians can only do so much, that the frailest of the rich world’s economies will eventually crumble under their financial commitments and be pushed into default and depression?
Economist Ed Yardeni coined the term “bond vigilante” in the 1980s to describe institutional investors who protest fiscal or monetary policy they consider inflationary by selling or shorting bonds. Bond holders simply want to protect their money and anything governments do to stoke inflation or put themselves in a default position threatens the value of their holdings.
Inflation is bad for bonds because they have a fixed payout, so as the value of money depreciates the real value of the interest payments to investors declines as well. Selling bonds drives up yields, increasing borrowing costs for governments and generally raising the cost of credit.
The phrase “vigilante” could also be applied loosely to encapsulate shareholders. In the United States for the moment, the stock vigilantes are arguably doing a better job of protesting the political deadlock on fiscal management than bond vigilantes.
Safe-haven status for U.S. treasuries has shielded the bond market there but stocks have been driven down repeatedly in volatile sessions.
“It’s just a bunch of people who get riled up and decide to take law and order into their own hands because they don’t think the sheriff’s doing a very good job,” says Mr. Yardeni, who know runs Yardeni Research Inc. in Great Neck, N.Y. “They’re running wild.”
Nowhere has that been more evident recently than in Europe, where hedge funds and other fixed-income investors have for months stalked the debt-choked government of Greece, forcing the government to enact deep spending cuts in exchange for a bailout package from the European Union.
They then moved onto Ireland and Portugal before pillaging the bond markets of Italy and Spain, forcing the European Central Bank to intervene and buy those bonds, Mr. Yardeni and others say. The vigilantes quickly turned their sights on the United States during the debt-ceiling crisis, then switched back across the Atlantic this week to flush out more perceived feebleness in the eurozone, this time in France.
“It’s like a hunting pack” of wolves, says Stephen Lewis, chief economist with Monument Securities Ltd. in London. “They go first after one, then another — whichever they see as the weakest member of the troupe that they’re predating.”
Some market experts dismiss the vigilantes, especially stock holders, as mere speculators. Others say they’re different today than they used to be in previous crises.
China, for example, might be considered a vigilante. It holds more than $1-trillion in U.S. treasuries and its state media has been highly critical of U.S. lawmakers, accusing them of failing to tackle debt levels. “The U.S. government has to come to terms with the painful fact that the good old days when it could borrow its way out of messes of its own making are finally gone,” said a commentary piece this week in news agency Xinhua.
The response by politicians and central bankers to market vigilantism has been mixed and sometimes meek. When the market was selling off Italian and Spanish bonds and yields pushed past 6%, it was a message to policy makers that they goofed in trying to contain the crisis to the periphery of Europe.
“The higher yields showed that the medicine that the European officials had been trying was failing,” says Marc Chandler, global head of currency strategy at Brown Brothers Harriman & Co. in New York. He describes the current situation roiling the developed world’s economies more as a “tug-of-war” between policy makers and investors than an all-out market riot.
Much of what the vigilantes are afraid of now relates to political risk. Such risk mostly applied to emerging markets before — Ecuador, for example, has stiffed foreign investors at least twice by defaulting on its external debt, with its president calling what it owed outside creditors in 2008 “immoral and illegitimate.” But now it raises questions about the solvency of even the biggest and strongest Western governments.
For the past three years, investors placed their faith in political leaders to sort out the financial mess, particularly in Europe and the United States. Now that faith is broken.
The U.S. Congress struck a debt-ceiling deal that leaves the real budget-cutting to a bipartisan committee that may fail to reach consensus, meaning another debt crisis may be just a few months away. And the eurozone doesn’t seem to have the right tools to deal with its own problems once and for all. A much bigger rescue fund will likely be needed to save the currency union, people interviewed for this story said.
It all boils down to too much debt and too little political resolve.
In the case of Europe, the markets have uncovered flaws in the way the eurozone was put together, says John Lonski, chief economist at Moody’s Investors Service. They’ve laid bare the inconsistencies between a single monetary policy and many different fiscal policies and they’ve punished countries that are not forthright about their budgets.
Still, that doesn’t mean they are always correct in their assessments, he said.
“Markets can be wrong. They can overreact in both directions, in the upside and on the downside… Quite frankly, they perhaps are also prone to misjudging the ability of a country to service its debt obligations over time. The idea that the financial markets are perfect predictors of what lies ahead for either corporations or countries is absurd.”
There is also a clash between what bond vigilantes want and what average people want.
As global populations feel the squeeze from two directions — mediocre income growth and higher goods prices — being a self-proclaimed ‘bond vigilante’ feels somewhat uncomfortable, writes Jim Leaviss, head of retail fixed interest for U.K.-based M&G Investments, who started a blog with colleagues called bondvigilantes.com.
“Is it right that the markets should have the power that [Clinton administration advisor] James Carville talked about in his famous quote, [saying the bond markets ‘can intimidate everybody’? Is an AAA credit rating worth more than a half million jobs? Is stable inflation more important than growth? Or maybe we should ask, like the soldiers in this Mitchell & Webb video, ‘Are we the baddies’?”
Nicholas Spiro, managing director of Spiro Sovereign Strategy in London, agrees that bond vigilantes have been active in Greece and Portugal. But he says what many people are taking to be the work of vigilantes in other markets is actually a much bigger crisis of confidence involving a larger group of investors.
In the case of Italy, he says, it wasn’t a case of bond vigilantes shorting the country’s treasuries and thinking they could test its leaders. It was a wholesale flight out of Italian debt because of uncertainty about the future of the 17-nation euro group.
“There isn’t bond market vigilantism now. There is something which is far more pernicious in its effect. Bond markets are reeking of fear and panic now. And the real worry is that you have a self-fulfilling slide in the markets and a vicious circle. When sentiment [swings], it’s very difficult to turn the boat.”
European bank shares are becoming a conduit for investor angst over the eurozone, he argues.
Mr. Spiro likens the Europe debt drama to a maze ending in a fiscal union. He says politicians and investors are all scrambling to try to find the finish.
“We will see a Lehman Brothers-style type moment in Europe at some stage,” Mr. Spiro predicts, dismissing forecasts by other market analysts that a collapse similar to the U.S. investment bank in September 2008 won’t happen. “Right now, we are in a collapse of confidence which is the worst since 2008. In terms of the bearishness and in terms of the VIX index [measuring the implied volatility of S&P 500 index options], this is as bad as it has been. There is nowhere to hide.”
Source: National Post