Are The Bond Market Vigilantes Back?

A WSJ article Saturday questions whether the bond market could derail the government's plans for healthcare and energy reform as it did back in the early years of the Clinton administration when the "bond market vigilantes" forced the government to sacrifice its healthcare project and instead address deficits.
For the sake of the economy and the millions of American's looking for jobs - not to mention the global outlook - one would sincerely hope not. The days when markets dictated policy are hopefully behind us once and for all; had we been a little less subservient to market demands (for unfettered trading, light regulation to avoid stiffling innovation, low taxes etc etc) in the first place, we may not have found ourselves in quite such dire straits.
That's not to say that the Treasury market jitters are unreasonable. The U.S. is after all embarked on a once-in-a-lifetime experiment that involves not just massive spending to get the economy out of a recession and restore an embattled banking sector to health. Officials are also attempting to rebalance growth so that it's less consumer-dependent even as demand in the rest of the world is weaker than it's been in a long time, while restoring the flow of credit to the economy without reviving the heavy dependence on leverage and the shadow banking system that was ultimately the root cause of the credit crisis. There's no blue print, no model for what policy makers are doing - from the Fed's many innovative liquidity programs to the Treasury's Auto Task Force. Hence the Treasury market's jitters - in fact, we should all be apprehensive: there are no guarantees that this will work. But equally - and the cooler heads in the bond market will agree - there isn't a palatable alternative.
The bond market is looking for guidance from the Fed as it contemplates the risky path policy makers are taking. Right or wrong, it saw a subtle signal in the Fed's mortgage bonds and agency debt purchases Thursday and Friday, when the bank bought larger amounts than in the prior rounds. It'll be looking for another signal on Wednesday, when the Fed buys Treasurys in the seven to 10-year maturities, just ahead of Thursday's announcement by Treasury of the next round of auctions which include reopenings of existing 10- and 30-year maturities - the ones where all the worries about inflation, unsustainable deficits, and ratings downgrades crystalize. There's one more opportunity for the Fed to send a signal to markets before that announcement: Early Thursday, New York Fed President Bill Dudley addresses a SIFMA conference (though how receptive markets might be remains to be seen - many still remember his March 6 speech when he indicated that Treasury purchases weren't on the table, only for the March 18 FOMC meeting to announce the immediate start of such purchases.).
Central bankers are probably hoping to be able to keep the market on an even keel until the June 23-24 FOMC meeting when they will have the opportunity to discuss the future of the Treasury purchase plan, which runs out in September, and perhaps even more importantly, start addressing in specific their exit strategy. They might just succeed, though it won't be smooth sailing.

What To Expect From The Fed On Wednesday

The Federal Reserve's rate setting committee meets on Wednesday - what should we expect from the statement? It's unlikely to be as explosive as the March 18 one (when despite clear signals to the contrary - including a very definitive statement by New York Fed President Bill Dudley 10 days earlier - the FOMC opted to significantly ramp up its mortgage purchase program and to start buying Treasurys to manipulate the yield curve); it could sound a little bit less concerned on the economic front, if the Beige Book and Fed Vice Chair Donald Kohn are anything to go by (but see above, one might want to be careful when reading Fed tea leaves.)

The Treasury market is inclined to push yields higher and test the Fed's mettle - already Friday, the 10-year yield briefly poked its head back above the 3% mark. The thinking is that the Fed will have to buy more than $300 billion worth of government debt to keep long-dated yields in check - and though the consensus seems to be for now that policy makers won't want to announce an expansion of the program, we've learnt our lesson on that (see once again above).

What's more, there are good reasons why the Fed might want to announce an expansion of its purchases now: if policy makers do see some kind of stabilization in the economy, why not double down and make sure the 10-year yield stays below 3% to ensure it stays that way? That's particularly as the consumer remains the weakest link: job losses will continue to rise - April's unemployment rate could touch 9% (it was 5% in April 2008, just for comparison) - and don't be fooled by those who say jobs are a "lagging indicator". That's only a comfort when there's another source of demand (typically exports) that can help get the economy growing again - but remember, this time, we're in a synchronized downturn so that historical leg of recovery won't be of much help.

A freaked-out consumer, terrified of losing his/her job, a global economy mired in a lack of demand - maybe adding another $750 billion to its Treasury purchase program might not be the worst thing the Fed could do.