Bond Vigilantes Who Gave Bush a Pass May Ambush Obama or McCain

By Matthew Benjamin

Aug. 11 (Bloomberg) -- The bond vigilantes who've been missing in action under George W. Bush may be preparing for a return engagement once Barack Obama or John McCain takes office next year.

Investors and former policy makers predict that the same market forces that torpedoed President Bill Clinton's ``putting people first'' spending initiatives at the start of his presidency are gathering again at the prospect of McCain's tax cuts and Obama's health-care and education programs.

``Though times are different and a lot of the government spending is necessary, we're going to see rates rise in a saw- tooth pattern over the next few years,'' says E. Craig Coats Jr., the head of Salomon Brothers' government securities desk when it was the world's biggest bond trader. Coats considers himself one of the original vigilantes, the bearish traders who drove up long-term interest rates, persuading Clinton to place deficit-reduction above fulfilling his spending promises.

That course-reversal prompted Clinton political adviser James Carville to observe 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.''

Economists and traders say the prospects for increased government borrowing needed for either McCain or Obama to enact their proposals will again lead investors to shun Treasuries and push up interest rates. Ten-year yields are forecast to reach 4.63 percent by the end of 2009, according to a Bloomberg survey of 68 economists.

`Huge' Demand

``The demand from the Treasury is just going to be huge,'' says Coats, 62, who is now the co-head of fixed income at Keefe, Bruyette & Woods Inc. in New York.

The bond bears have largely been invisible during Bush's presidency, even as tax cuts, expanded government spending, wars in Iraq and Afghanistan and two economic downturns drove the federal budget deficit to a record $412 billion in 2004 and to the forecast of another record -- $482 billion -- in fiscal 2009.

Today's 10-year Treasury yield, about 3.93 percent, is actually negative in real terms, with consumer prices up 5 percent in June from a year earlier, the biggest jump since 1991.

Economists and bond managers say Bush's free ride has basically been the result of two forces: contained inflation through most of his presidency, and the nearly insatiable demand by foreign investors and central banks for U.S. debt.

``China and other governments have not been demanding higher interest rates as the deficit increased because their main motive has been to prevent their currencies from appreciating,'' says Brad Setser, an economist at the Council on Foreign Relations and former U.S. Treasury official.

Changing the Equation

Now, at least part of the equation that favored Bush is changing, says Ajay Rajadhyaksha, head of U.S. fixed-income strategy at Barclays Capital Inc., one of 19 primary dealers that trade government securities with the Federal Reserve.

``The one thing we had going for us at that time was inflation credibility,'' says Rajadhyaksha. Now, he says, ``that credibility is starting to erode for the first time in two decades. So it becomes far less certain that foreign investors will continue to bail us out.''

To be sure, some major bond rallies have occurred when the federal deficit was widening, says Edward Yardeni, who coined the term ``bond vigilantes'' as chief economist at EF Hutton in 1983. That's because government debt tends to balloon in recessions, which also prompt a flight to the quality of Treasuries.

`Rotten' Financial Systems

Still, says Yardeni, now head of Yardeni Research Inc. in Great Neck, New York, deepening deficits, ``rotten'' financial systems and government intervention in the economy mean ``there could be a renewed flight from the dollar and from our bonds.''

Leon Panetta, Clinton's first budget director, says that ``if we continue to run these large deficits, not only bond traders but the securities markets are suddenly going to awaken with concern about whether or not the administration is doing anything to discipline the budget.''

If that happens, Panetta says, ``it's just a matter of time before they start to put pressure on a new administration.''

Clinton's experience shows what such pressure can do to a president's agenda. Promises of spending on education, public works and a middle-class tax cut fell by the wayside as advisers led by Robert Rubin, who later became Treasury secretary, convinced the new president the best thing he could do for the economy was to show investors his resolve on fiscal discipline.

Clinton's Rage

``You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of fucking bond traders?'' Clinton raged at aides, according to journalist Bob Woodward's book, ``The Agenda.''

Clinton's deficit-reduction policies resulted in a sustained economic boom that generated budget surpluses from his last four budgets and helped pull 10-year yields, which topped 8 percent in 1994, below 5 percent by the late 1990s.

Just as Bush benefited from the achievements of the Clinton years, gaining room to pursue his initial tax-cut agenda, either McCain or Obama will likely be under immediate pressure to fix the problems left over from Bush.

``Government borrowing is annoyingly high,'' says Jeffrey Gundlach, chief investment officer at Los Angeles-based TCW Group, Inc., which has $145 billion under management. ``In the long term, we're looking at rising yields,'' says Gundlach, 48, who has managed bond funds for more than 20 years.

Adding to the Deficit

McCain's tax-cut proposals would add more than $400 billion to annual deficits by the end of a first term, while Obama's would widen the budget gap by almost $300 billion, according to the Tax Policy Center, a nonpartisan research group in Washington. Obama also proposes at least $130 billion a year in new spending by 2012 on health care, energy, education and infrastructure, among other programs.

Either outcome is unwelcome for bond investors, says Bill Gross, manager of the world's largest bond fund at Pacific Investment Management Co.

``To the extent that either one of them believe or pretend the budget deficit is going to be balanced in their term, they are talking fiction,'' Gross said in a Bloomberg Television interview last week.

Gross's Letter

In an open letter to Obama in July, Gross said the Democratic candidate's spending plans would fuel inflation.

``Intermediate and long-term yields on government bonds have already bottomed and will gradually rise throughout your first, and perhaps second administration,'' Gross wrote.

Gross didn't send a similar letter to McCain. Organizations advocating balanced budgets, such as the Washington-based Concord Coalition, say the Republican candidate's plans would create bigger deficits.

For either a President Obama or a President McCain, the best hope may be the possibility that markets have changed so much that vigilantes won't be able to wield the clout they did in years past.

``Markets are much bigger and much more closely linked to different options and derivatives'' than they were in the 1980s and early 1990s, says former vigilante Bjoern Wolrath, making it far harder for investors to influence events.

In 1994, Wolrath, then general director of insurer Skandia Group, declared that Skandia was ``not going to buy a single Swedish bond'' until the government adopted a credible policy to rein in deficit spending that had swollen to 13 percent of the nation's economy. Sweden this year is running its fourth consecutive annual budget surplus.

Those days are past, says Wolrath, who now serves on the boards of corporations that include one specializing in clearing land mines. Referring to billionaire George Soros's legendary 1992 assault on the British pound, he says, ``Not even Mr. Soros would have a chance of having an effect on the big capital markets any longer.''

To contact the reporters on this story: Matthew Benjamin in Washington at mbenjamin2@bloomberg.net.