Odd Lots - The Inventor Of 'Bond Vigilantes' Explains Why They Just Showed Up In Italy

Episode Date: June 11, 2018

Longtime market analyst Ed Yardeni came up with the term "Bond Vigilantes" to describe the way bond market participants can punish governments who run economically irresponsible policies. When Yardeni used it in the 80s, it referred to US fiscal policy that was thought to be inflationary. Now the bond vigilantes are back, but this time they're in Italy. On this week's podcast, Yardeni explains the history of the term, what's going on now, and how interest rates can be used to model stock market valuations.  See omnystudio.com/listener for privacy information.

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podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen. And welcome to another episode of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. Joe, what is the most overused quote in all of financial journalism and commentary? I don't even know where to begin with that question.

I don't know. I'm stump. Well, it might not be that obvious, actually. Okay, in my humble opinion, it has to be the quote by James Carville, the Bill Clinton advisor. about the bond market. Did you ever hear that one? Oh yeah, yeah. I love that quote. The one about James Carville saying that he wishes, or he said if he wants to, if he gets reincarnated, he'd like to come back as the bond market because that can scare everyone, right? Something like along those lines? Yeah, that's a pretty good paraphrase. He said so that I could intimidate

everyone. And I have to say, if you're, if you're a financial writer, I guarantee you at some point or another, you have probably begun a column or a story with that quote. But I think that's probably fair to say. Yeah. And I'm certainly guilty of it. I have to admit. But there's a reason that it resonates so much, which is that the power of the bond market is something that we're constantly discussing.

And Joe, you'll remember a couple episodes back, we did have one episode where we were discussing the return of the bond vigilantes. Yeah, absolutely right. And it's what the bond vigilantes. It's this idea that from time to time, policy makers have their actions rejected forcefully in the bond market. And they're cowed into action by what the market is telling them, so to speak. That's right. So it's the idea that the bond market can act as a constraint on fiscal policy by basically raising a government's borrowing costs.

And the reason we bring it up now is because in addition to the U.S. context. You know, we had that big rise in U.S. bond yields and people were talking about whether or not bond vigilantes were coming back because the U.S. was embarking on this big fiscal expansion. We've also seen the power of the bond market in recent weeks as demonstrated by what's been going on in Europe and specifically Italy. Yeah, the old, the old Euro crisis story is coming back in Italy. That's right. It all feels very 2012. We saw a big blowout. in Italian bond spreads. Everyone got very excited, started dusting off the old fiscal playbooks from circa, you know, 2010, 2011, 2012. And we all got to talk about the bond market reaction

to Eurozone political and fiscal drama once again. So that was very exciting. But of course, you know, we do have this ongoing discussion about the bond market in general, but also how it relates to U.S. equities. And on that note, because we had the big rock. in U.S. bond yields earlier this year, we have seen short-term rates on government debt actually go above the U.S. dividend yield for the first time in many, many years. Yeah, I've seen a bunch of versions of this chart lately. And you mentioned the idea of short-term bond yields going above dividend yields, but there have been various variations on it. But the general theme seems to be that for the first time in a long time, in a long time,

time, you can get paid a decent amount of money owning short-term government debt, which carries very little real risk. And the competing yield you can get from equities, whether we're looking at the dividend yield or just the straight-up earnings yield, which is the inverse of the PE ratio, is looking less juicy by comparison. Exactly right. So we're talking about a lot of different things here. And the reason we're doing that is because we actually have a really fantastic guest for this episode who is able to thread all these different subjects together. And he is actually the person who coined the term Bond Vigilantees. So that's exciting. Oh, wow. So now I feel very self-conscious from having tried to give my feeble definition of the term because we are literally

going to talk to the originator of it. All right. Well, without further ado, then let's bring in our guest, it's Ed Yardeni. He is president of Yardini Research. Ed, thank you so much for joining us. Thank you very much. And by the way, I think you got it all spot on. Okay, few. That's a big relief. That's a shame because my first question to you was going to be to ask you to embarrass Joe about his definition. But I guess I don't get to do that now. No, I think both of you got it right on. So should we start with Bond Vigilantes and just go back in time and talk about how. you came up with that term? It was back in the summer of 1983.

The policymakers weren't doing right by keeping inflation down. And I think there were three or four episodes in the 1980s where bond yields rose, nominal GDP growth slowed substantially. The heyday, the 1980s in the United States. Now, something I've always sort of been a little bit unclear on with respect to the term is the idea that people in the bond market who are are buyers of bonds or traders of bonds somehow take on the role of the vigilante who enforces justice on their own? Or is it more that bond market or bond market participants in the course of

their normal assessment of risks and trading and positioning their portfolios suddenly take a vigilante-like role towards policymakers? So is it a more active conscious thought, I guess, Or is it more sort of descriptive of the relationship that naturally emerges during times when a government is being punished for policy mismanagement? Yeah, I think it depends on the circumstances, depends on the, if the policy mistakes are policy saddles up and today's fundamentally. But there's other times when bond yields go up sort of a natural course of thing. So I have a related question about the time frame that we're looking at because often the trajectory of sovereign debt, doesn't change on a day-to-day basis, just to be clear. You could have news about a big policy change and then the bond market reacts to it, but normally you get sort of a gradual direction

that you're heading in. So when we see something like what happened with Italy, let's see, in late May, when suddenly the market seemed to wake up to the realities of Italian indebtedness, what exactly is going on there? How are bond markets actually reacting to the situation? Well, again, this is consistent with our discussion that in the 1980s, in the case of Italy, the issue wasn't inflation more serious, which was credit quality. It's one thing to own bonds is when inflation is think in the Italian situation, the bondagellani's were said in Italian. The idea is, you know, by Moody's. Moody's will empower the, Bonavigilani by downgrading the credit.

One thing that I find to be interesting about Italy, I was, I traveled there in early 2013 during one of their previous elections. And I imagine if you ask the average American what the U.S. 10-year yield is yielding, you would get a range of either numbers or just completely blank stairs. Like, it's not something that many people think about. But in Italy, it's kind of like they're Dow Jones. S&P, everybody knows what is. The term Los spread is in the news and politicians talk about it.

Everyone's acutely aware of the spread of Italian bond yields to German bond yields. And so it really does have that effect of policymakers, conscious of the spread and wanting to bring it down for domestic political reasons. The monetary unification, the introduction of the euro to the euro zone, quite wide. In other words, 1999, the euro was introduced, and lo and behold, Everybody came to the conclusion that European bonds were all the same. It'll leave. What is it?

It'll leave. It'll leave. I like that one. I knew there's something out there. So let me segue to something else that's happening in Europe or on the edges of Europe, depending on where you stand politically. But over in Turkey, we've also seen some financial drama where President Erdogan is basically exerting influence on the central bank and trying to prevent them from hiking.

interest rates at a time when arguably there is a lot of inflation and they should be hiking interest rates. So if you were to ask Erdogan about bond vigilantes, I'm sure he would probably shake away any of their concerns and say that the bond market isn't the right entity to be exerting political influence over fiscal decisions. So I'm just curious, do you think the bond market should be influencing political or fiscal decisions? I tell people, I'm not a I don't do good or bad. I do bullish. I deal with the facts seem to be a... They weren't... Turkey was getting some pretty good rates. Look, the Bonnevigilante is always sort of blatantly. What we're seeing here is kind of global Bonne Vigilantes. It's certain Turkey that have pushed into the abyss that's been foreigners who they turn unacceptable in Turkey. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world.

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That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. And you talk about how the bond vigilantes settle up at sort of random times throughout history. So there were a few episodes in the U.S. and the 80s related to anxiety overinflation. And now, of course, Greece and Italy. And one of the things that we know about markets and extreme market moves, markets are complex systems. And we never really know what catalyzes any extreme move.

So we can try to pinpoint something like, oh, you know, maybe there was some data release or some comment that Erdogan made or something that a politician in Italy said. But we know that these are at best just approximations. And it's very hard to really talk about why a market shifts from one regime, of potential complacency to another regime of sort of the market playing a disciplining force. In your work, looking at the bond market, do you have any insight into what it is that's sort of how the posseal sort of coordinates and gathers up or settles up and shifts from one mode into the other? Over the years, the bond market just kind of gotten the rules of the game, which is the bond market, first and foremost, wants to make sure that inflation remains. Maybe I shouldn't say first and foremost because just as important.

Which more important is making sure that you get your money back, the inflation rate and the credit risk. And very often what happens, policymaker's message being sent by the, make sure you satisfy the bond market and then everything else will fall into place. So I'm going to shift into a different regime now to try to draw a connection between what we've seen happening in bonds, specifically in the U.S. with the recent rise in rates, and what's been happening in the equity market. And here as well, Ed, you have been very influential because you actually came up with a model that's well known in the investment world now, or at least you put a name on the model. It's called the Fed model. could you possibly walk us through how this works? The term I gave it was the Fed stock valuation model. And back in 1997, it was the summer in 1997, the Fed released its monetary policy report. I don't think anybody ever reads that report, but I skimmed it.

And it's the end in 1996 that Greenspan gave his famous question, asked the question, helped the boss figure out the answer to that question. And they came up with a model that actually been around for a world. while just hadn't been given as much attention to prior to them mentioning in the monetary policy report. But the basic idea is that the stock market certainly is influenced by the business cycle, but in terms of long-term rates, they are an alternative to stocks. The difference between bonds and stocks is if you buy a bond and hold them in maturity,

you'll maybe purchasing power. Stocks, on the other hand, give you a yield based on their dividends, but they also have a lot more upside. So what the Fed did is they showed a chart of the 10-year U.S. Treasury bond yield, and then on the same chart, they showed the S&P 500 forward earnings yield, the PE, instead of it's the earnings yield of the S&P 500. Currently, well, let's say in May, S&P 500, and the bond yield is more like 3%. That implies that stocks are 50% under valued. The problem with this model is it's been arguing that the stocks

are undervalued ever since 2001, 2002, which on balance really wasn't a bad call. I mean, look how much higher we are now than we were back then, but it certainly did not anticipate the 2000. He got to use it with some caution. In other words, the model really worked

very well prior to when the Fed discovered it. They discovered in 1997. It worked like a charm. And then it worked for another couple years, told you to get out in 2000, 2001, and then it wasn't really of much use since then. Yeah, so this sort of gets to where I was going, which is that there is an intuitive appeal to the model, which is that you have this risk-free asset class that tells you up front how much you're going to get paid, and you can discount that future stream of cash flow is a very predictable way.

And then you have this risky asset class, and you don't really know much, but you can sort of see how it compares or what it's offering versus the risk-free rate. But as you said, and as many, as others have pointed out in finance, the only problem with it is that it often doesn't work and you can't really use it to time the market. So how should an investor incorporate it into their practice if it sort of often fails at timing the market? The markets, and I do discuss this model in great detail. But I think, I think one of the things I've learned over the years is that the bond vigilantes aren't the only players in the bond market. There's also central banks.

And one of the reasons that bond yields of states are very powerful structural, secular forces that have been keeping inflation down. And the number one preoccupation of the bond vigilantes is inflation in the United States. They don't worry quite as much about the credit quality of government bonds. So far so good, I should say. But here's what I've come up with, and that is that the stock valuation model in some ways is sort of misleading because that term doesn't really say what it is. It's a stocks versus bonds valuation model, and it may very well be that it isn't that stacks are grossly undervalued.

It may be that the bonds are grossly overvalued, and the yielders have been kept too low by the central banks. and now that they're normalizing, we should see a more normal relationship in this model. But I really think the model actually still is useful, not as a stocks versus bonds asset allocation model. I think investors should view it more as a corporate finance model. I found that we can relate the buyback activities that we're seeing in the S&P 500 companies to the spread between the forward earnings yield, again, the inverse of the PE, and the cost of borrowing in the corporate bond market.

And on an after-tax basis, and right now I reckon, in an after-tax basis, corporations can borrow money like on average, good and bad quality, averaging them together. And the forward earnings yield is 6%. So you almost have a fiduciary responsibility if you're running a corporation to borrow that cheap money

and buy back your stocks. And so I really think I've sort of salvaged the stock valuation model, by pointing out that it actually has work, but that is a bonds driving this bull market. Two things there. It's a really interesting point. Does that mean that the major risks to equities now are that the buybacks actually stop, as a lot of people have been concerned that they might? And secondly, is the major risk also a derivative of what might happen to bonds if we start to see inflation come back or if central banks start to wind down their extraordinary stimulus. Yeah, I mean, I think you got it right on the money, and that is since buybacks have been the

major reason why we've got, have had this bull market, you remember, been on a few of them, they say, wait a second, there's another buy here, shares and that's been trillions of dollars of buybacks. Now, I'm not terribly worried anytime soon that that's going to stop because we've got a bunch of money coming change at the end of last year, and I think a lot of that money is going continue to go into the bond yield, even though it's come up, but it's still below the forward earnings yield of the S&P. So there still could be some borrowing. General statement, if something happens that for some reason, the biggest, we've all gotten pretty lulled in thinking that inflation is tame this. I'm looking for it for a single day,

not because I expected to come back, because forecasting going to look pretty silly. You've got to be flexible and open-minded about these things. But yeah, I mean, if inflation makes a comeback, all bets are off. Then you get higher bond yields, maybe. So reapplying your sort of altered Fed model of forward earnings yield versus corporate borrowing costs, thinking back to this approach in the pre-crisis period 2006, 2007, I'm curious, A, whether that would have been a more useful signal than the sort of pure earnings yield versus 10-year rate. And B, how much is the problem still that, you know, forward earnings yield is just a guess? And very few people would have really predicted that earnings were about to drop off a cliff during the great financial crisis.

My bottom line on the markets is their markets are caused by recessions. But I think I don't really know of any model that, particularly GDP model, they were all of them. And they did the same thing. I would say that there are alternative valuation models that have been more useful with the benefit of hindsight. The problem with a lot of those models is, especially the Cape model, the Schiller model, is it looks at earnings over the past 10 years. And so it's always going to be more better valuation metrics that looking forward, which is the Fed model or just the straightforward forward PE.

So I think you want to look at valuation models. You want to look at all of them. You want to decide for yourself. What you really got to get right is right now, S&P forward PE is around 6,000, 16, 16 and a half. That's not cheap. It's not terribly expensive either. But if there's not going to be a recession for the next several years, then the peak you could go up. If there's a recession right around the corner, you don't want to be in stocks. I think the expansion is going to last a while. I'm terribly concerned that valuations are too extended.

All right. Well, Ed, that has been an absolutely fascinating conversation, and it was such a pleasure to have the inventor of the Bond Vigilante's term actually on the podcast. to discuss it. So thank you so much. Thank you. So, Joe, I love that conversation because, partly because we managed to cover so much ground and we really kind of thread the needle between U.S. bond vigilantes, what's happening in Europe, not just Italy and Turkey, but also what's happening with U.S. equities. So an all-round general topics, Othotts podcast, I would say.

Yeah, it was really good and very timely because, as you know, that term bond vigilantes is controversial. And some people think it's kind of a myth. But I think Italy is a very crisp example where you see the market reaction in the bond market immediately applying pressure to politicians. And they look to that number and feel like, okay, we're getting a rejection from this crucial market. And to some extent, that forces them to consider reversing course. So the metaphor works very nicely in this context, I think. Yeah. And I love that anecdote you have of your visiting. it to Italy where everyone on the street is talking about the two-year Italian bond deal. I love it.

Or was it 10-year? I can't remember. Either one, I think. Lo spread. Yeah, Los spread. That's fantastic. So the other really interesting part of that conversation, of course, is the Fed model. And you've actually seen it making a little bit of a comeback, given the concerns over the

rise in U.S. rates. So that's interesting as well. Yeah. And again, this is another one of these controversial things where some people say, no, it's not useful. You can't really do anything with that. Others say it's important for understanding some level of the stock market's richness or cheapness. But I really like that last point he made a lot, which is that, look, in the end, what causes bear markets is economic downturns. So no matter how great your valuation model is, there's no shortcut for trying to have a view on what's going to happen in the future. If you want to time the market and you don't. don't have some ability to look ahead a little bit in terms of what's going to happen in the economy, no matter what your valuation model is, you're probably not going to do very well. Right. Although I have an opposing pet theory, which is that if you consider that the recovery

that we've seen since the 2008 crisis took place mostly in financial markets, then maybe it makes sense to think that whatever recession is coming up is going to be sparked by financial market turmoil as well. But that's sort of controversial. So I'll stop there. Tracy, do you want to be a guest on a future episode and I can interview you about your theory of financial markets and the real economy? You're inviting me to be a guest on my own podcast. Thank you, Joe. Thanks, Joe. No, I won't. But it's an interesting discussion. I enjoy discussing it with you now, Joe. That's enough for me. Okay. This has been another edition. of the Oddlots podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway.

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