Bond Economics

Yet More U.K. Bond Market Vigilantism

2026-06-05T11:23:04.540-04:00

I have been getting ready to leave town, and so wrapping up other projects. The only thing that popped up in my internet browsing was the Return of the Bond Market Vigilantes, this time courtesy of a tweet on May 30th by the U.K. Green Party Leader, Zack Polanski. The short text was “We must stop being in hock only to the bond markets. No one voted for the bond markets.”

I am unsure about the exact context of his original tweet, and it appears to have been a one-off comment. I am not going to attempt to delve into Polanski’s full views on bond markets are (it is clear that they get the usual suspects mad, but the summaries I do not have great issues with), rather I just want to comment on the discussions online that were provoked by that statement.

No Point in Worrying About Bond Markets

My unsolicited advice to the centre-left (particularly in the U.K.) is to not reinforce the “Bond Vigilantes are more powerful than the government” narrative that characterised the post-1990 neoliberal consensus. If you are a Green Party supporter, you are likely correct that the average bond market denizen is not a fan of your favoured policies. Realistically speaking, there’s probably a lot of other people in the U.K. that also do not like your policies. For example, I doubt that the fox-hunting set are fans either. This does not matter because it seems implausible that fox hunters have a veto on government policies. The problem with the focus on bond market vigilantes is that they do not have a veto on government policy either — you need to look at the “independent” arms of government policy, like the Bank of England.

The bond markets do not exist solely because they benefit rich bond market investors. They exist because they reflect economic, accounting, and financial fundamentals, and you would need to do something about those fundamentals if you want to make anything other than a cosmetic change to the situation.

One of the unfortunate side effects of the explosion of Modern Monetary Theory (MMT) on the internet is that it picked up some bad habits, that then transitioned to related online economic communities. For my purposes here, there are two concerns. The first is that the “Mint the Coin” episode became too much of a role model. (The idea was to mint trillion dollar platinum coins in the United States to get around the debt limit.) Although ingenious, this was a cosmetic change that only worked because the Debt Limit is just a stupid cosmetic rule. The second is that the emphasis on operations led too much importance to being attached to minutiae of money market structure. Although details matter, we cannot lose sight of economic and financial forces. The rest of the article explains what I mean by the previous sentence.

Why Bond Markets?

If we make some simplifying assumptions about the accounting, the central government’s net deficit in a year equals its emission of financial liabilities. (The simplification is that the government is not doing anything that generates/consumes cash flow that is not affecting the deficit; most of the time, the deficit is close to financial liability emission.)

The government could theoretically issue equity, but most governments do not have profit-making enterprises that they can sell minority stakes of to the private sector. To the extent that this is happening, this is “privatisation” and “Public-Private Partnerships,” which are of course, neoliberal.

This only leaves us with the two categories of liabilities: cash, and debt. That breakdown is from the perspective of the owners of the liabilities. The government can call them whatever they want, but what matters is what the people who hold them think about them.

“Cash” as I use it fits the definition as used in portfolio management: short-maturity debt instruments. Central governments issue a variety of cash instruments:

banknotes and coins;
deposits at the central bank (“reserves” in Economics 101 textbook-speak);
short-dated debt securities (“Treasury bills”);
repurchase agreements (“repos”), typically with the central bank;
short-term loans to the government or central bank, including accounts receivables.

“Debt” is every other liability (excluding equity, which sometimes get lumped in with liabilities). Although governments could originate a variety of debts, they generally stick to bonds.

Given that there is a finite appetite to hold government-issued cash instruments (as discussed below), the bulk of deficit spending ends up expanding government debts, which are mainly bonds. Although one could theoretically issue other debt instruments than bonds, they would be economically equivalent to bonds from the perspective of the owners of that debt. Which means that you can either make a cosmetic change and relabel “bonds,” or you can run balanced budgets. Or you lock interest rates at zero, which is the only truly fundamental change you can make.

Why Not Just Issue Cash/Money?

The immediate response I would expect to the previous statements is that the government can just issue “money” (deposits at the central bank, presumably). Of course, they already do. The problem is that the private sector is already at the limit of the amount of 0% interest rate money it is willing to voluntarily hold. One of the wackier theories that you can run into online is that there is “an infinite demand for money,” which is not true. There is perhaps an infinite demand for wealth, but the consensus of every serious attempt to model economies is that money holdings are determined by a portfolio balance argument (including transaction demand, including the underground economy).

Since the whole point of money is that it is easily exchanged for other goods and services, it is difficult to get the private sector to hold it involuntarily. The only scheme that worked in practice is forcing banks to hold required reserves against deposits. However, this is a tax on the regulated part of the financial system — tilting the playing field towards non-traditional bank finance (“shadow banks”). (Note that real-world banks in practice are generally holding companies that include traditional banking and shadow banking subsidiaries. Favouring “non-bank finance” just means which subsidiaries are favoured within the “bank.”)

Any attempt to extend who gets stuffed with 0% money has the effect that the stuffees “sell their money” to buy government bonds — driving bond yields to 0% as well. Which means that the policy is economically equivalent to saying “let us lock the risk-free yield curve at 0%.”

You could try to escape this by paying interest on “money” — which is what central banks did in the aftermath of the ZIRP (“Zero Interest Rate Policy”) era. They had bought too many bonds, and banks were stuffed with deposits at the central bank. This was not an issue when the policy rate was at 0%. However, to raise interest rates, they needed to pay interest on central bank balances. Which means that we have just made a somewhat cosmetic change: interest-bearing bonds were replaced by interest-bearing deposits at the central bank. People can generate pretty much the exact same “markets will punish the government” story, since these stories already have a loose grip on reality even with a conventional bond market.

So Why Not Lock Interest Rates at 0%?

Locking the government yield curve at 0% is a MMT policy proposal. But if you look at online discussions and critiques of MMT, it is nearly impossible to find anyone who actually tackles the subject. All you will find are arguments about “printing money.” And it is not even necessary to “print money” to get to the 0% state: Warren Mosler floated a proposal was to issue Treasury bills at an extremely low fixed interest rate (for example, 0.25%) to soak up money creation (which is the role of bonds and bills). Although 0.25% is not exactly 0%, it is close enough for government work — and that rate could be fixed by statute, so there’s no “Treasury bill vigilante raising rates” story to spin.

From my perspective, there are three good political reasons to not waste political capital on the project of locking rates at 0%.

The vast majority of economists are against the policy. This even includes Post-Keynesian economists who theoretically should be politically aligned with progressive MMT economists. The idea is so far out of the world view of conventional economists that they barely can wrap arguments around it when “critiquing MMT.” You would also be taking on central bankers, who have a very large political presence in financial media.
Locking the government benchmark curve at 0% blows huge holes in the economic position of the pension and insurance industries. This is not just an issue for fat cats: insurance and pensions are critical components of the broad middle class.
Given that nobody else supports the policy, you are always one election away from the policy being reversed.

Realistically, if you wanted to go for a “permanent 0% rate policy” in a democracy, you would need to build a supporting bloc of at least more than a half dozen economists who show up in financial media in the country. Furthermore, to build such a supporting bloc, you would need to convince people that interest rates are not critical to the regulation of the economy. Running around telling people that bond market vigilantes secretly run everything in the economy is exactly 180 degrees out of phase with that objective.

Concluding Remarks

The demise of incumbent governments after the pandemic inflation spike is yet another major set of data points confirming that voters hate inflation. Containing inflation puts constraints on fiscal policy (although some progressives are coming up with regulatory schemes to fight inflation). But the political solution for progressives is straightforward: taxes are the price you pay for a civilised society, so they need to go up. The fight is to avoid listening to the worriers who would set them too high and strangle growth.

The worst political strategy for progressives is to emulate the brain trust of the Starmer Labour Party and embrace the bond vigilante story line, as that story line will always be invoked in a way that almost only constrains the left — right-wing parties have to do something extremely stupid (e.g., Liz Truss) to end up facing revolting bond markets.

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Bond Vigilante Musings

2026-05-29T11:21:03.034-04:00

Bond vigilantes are a popular topic in financial media. Part of this is that most people find government bonds boring, and they would rather read about equities, which can have more exciting returns as well as more interesting company and sector specific stories. Bond market vigilantes who are about to discipline naughty governments creates a fun narrative hook to a market that is otherwise characterised by daily price changes of around 20 basis points.

However, if you are actually paid to invest in bonds, the “bond vigilante” narrative is a trap. Government bond markets are boring, technical markets, and you do not want to get wedded to some directional thesis just because it feels good. You end up wasting part of your valuable risk budget on duration bets — which in practice almost nobody in fixed income has a track record of consistently making money on.

The Truss/Kwarteng Episode

Vince Gomez has an article on the 2022 gilt market scare in the U.K. when it had the hapless leadership of Prime Minister Truss and Chancellor of the Exchequer Kwarteng. As I wrote at the time, this episode is now highlighted whenever the possibility of loosening fiscal policy in the U.K. is raised.

However, the mythology around the episode ignores key points that are discussed in the article (and I discussed earlier). Although the incompetence of the Truss government helped trigger the panic, the panic was the result of U.K. pension funds somehow managing to completely hose the liquidity management of the derivatives portion of their Liability Driven Investment (LDI) strategies in 2022, just over a decade after the 2008 Financial Crisis demonstrated the importance of liquidity management. Given all the hand-wringing about systemic financial risk by regulators and central banks since that earlier crisis, the rather flat-footed response by the Bank of England to the 2022 panic is puzzling.

The article has a useful graph that shows that gilt yields tracked U.S. Treasury yields, and that without labelling the episode, the Truss Crisis does not stand out on the time series. One could argue that this was the result of the Bank of England intervention before things got too ugly, so I would be cautious about arguing that point.

The Full Funding Rule

The Gomez article argues that the “Full Funding Rule” used by the U.K. Debt Management Office is misguided. As stated in the 2025-2026 report (link):

An overarching requirement of debt management policy is that the government fully finances its projected financing requirement each year through the sale of debt. This is known as the ‘full funding rule’. The government therefore issues sufficient wholesale and retail debt instruments, through gilts, Treasury bills (for debt financing purposes), and NS&I products, so as to enable it to meet its projected financing requirement in full. [page 8]

This rule is designed to aggravate fans of Modern Monetary Theory (and Positive Money, which has a following in the U.K.). However, it is effectively meaningless. The consolidated U.K. central government “finances” its net deficit by the issuance of liabilities, which are both gilts and the expansion of the monetary base (“money”). (I used “net deficit” loosely as a synonym for “financing requirement” as there might be a gap between the fiscal deficit and net cash expenditures.) Since the balance sheet of the Bank of England is balanced, it needs assets to cover its increased monetary liabilities — and it owns gilts. Which means that the gross issuance of gilts has to match the increase in governmental liabilities.

The only way to not have gilt issuance match its “financing requirement” is for the Bank of England to break double-entry balance sheet accounting. Some people have argued that “money is not really a liability” so they are amenable to this approach, but there is no point in making arguments that will be ignored by everybody with a knowledge of accounting.

Fed Independence

Hopping to the other side of the pond, I periodically see hand-wringing about Fed Independence. Earlier in the Trump II regime, he was bulldozing the limits on Presidential power, and one could have imagined him installing some 20-year old sycophant as the rate-setting authority in the Federal Reserve. However, the ongoing political disasters due to bad decision-making by the White House makes such scenarios less likely. (The current projected line up for the 250th American Anniversary concerts currently consists of Vanilla Ice and somebody else, which is a humorous statement of the political momentum behind Trumpism. I am hoping that Vanilla Ice does not back out, as that is the funniest possible outcome for those of us who were in our peak music listening years in the early 1990s.)

Even if Trump installs lapdogs at the Fed, those lapdogs still need to win the votes on rate policy. With midterms coming up and President Trump approval ratings in the 30s, it is going to be hard to get people to commit career suicide by doing something really stupid with interest rates.

More realistically, they might be able to get the policy rate 50 basis points lower than otherwise. The economy is not that sensitive to interest rates, and that would not really matter for anything other than betting on money market forwards.

And even if Trumpists can surpass that 50 basis point level, we cannot ignore our friends, The Bond Market Vigilantes. Even though financial market participants are going to cut Republican Presidents a lot of slack, are the bond markets really going to ignore an inflationary accident? All it would take is a weekend of scary financial market prognostications to cause the President to panic and flip course. Even though I do not take the Bond Market Vigilantes seriously, there is no reason to believe that is not going to be true of the White House.

Which explains why I see little value in worrying about Fed Independence for anything other than tactical rate positioning (which is admittedly a popular side-line for rates investors).

Going Quiet Shortly

On an editorial note, I have been distracted by finishing a consulting project and springtime renovation projects before I head out for a couple of weeks. I might be able to get a piece off next week, but will likely be quiet thereafter (unless there is breaking Vanilla Ice news).

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Belated Comments On The AI Boom

2026-05-21T09:16:47.057-04:00

Animal spirits have been soaring in the area of Artificial Intelligence (AI), and the surge in spending has shown up in the figure above. It shows the fixed investment in Information Technology Equipment and Software as a percentage of GDP (ends in 2026Q1). The last two quarters of data saw a surge of about 0.4% of GDP.

This is certainly impressive, although the impact on GDP may be less than what the above figure suggests due to the associated rise in imported silicon chips — buying foreign equipment to invest locally improves the capital stock, but does not represent a rise in domestic production. (The exporting country is producing the goods.) This relates to one of the perennial online economics debates: do imports subtract from GDP? In addition to the statement “imports subtract from GDP” being mathematically correct, the cancellation of domestic spending does matter: there is a financial cost associated with buying foreign goods, and that financial cost can displace spending that would have been made on domestic production.

For more information, the article https://www.stlouisfed.org/on-the-economy/2026/jan/tracking-ai-contribution-gdp-growth by Hannah Rubinton and Bontu Ankit Patro of the Saint Louis Federal Reserve gives a more detailed breakdown of the effects of AI spending on growth. From a quick survey of publicly available research, there are arguments that the AI boom added 1% to American GDP growth, which is consistent with the linked paper (and the chart above). This helped insulate the U.S. economy from tariff shenanigans.

I have no real expertise nor interest in forecasting the future of the AI industry relative to other sectors of the economy. My interests are on the macro side, and my feeling has been that this has been a sectoral boom. This matters a lot to the people, firms, and investors involved, but the number of people involved are a limited slice of the population. This is different than the 2000s housing boom — there are a lot of homeowners, and construction as well as real estate are large employers. At the same time, the 2000s boom was a global boom built around wacky financial innovations. Even the technology boom of the late 1990s may not be directly comparable — there was a wider global investment boom that resulted from reversing the corporate retrenchment in the 1980s (as well as the beginning of the housing bubble).

It is straightforward to argue that the current growth rate of AI investment cannot be sustained, but that does not say very much (and is useless for equity investing). Investment levels could be sustained at “high” levels for longer than most sceptics would predict. Economic commentators tend to love forecasting popping bubble and the dire effects thereof, but my feelings on the sectoral nature of the boom also lead me to have limited worries about any potential retrenchment. My main concern is that a “popping of the AI bubble” would likely coincide with equity market weakness, and so “animal spirits” more broadly would be at risk.

The main risk to the global economy is the ongoing cut off of energy flows, which is hitting Asia and Africa first. There is a direct analogy to the Asian Crisis in 1997, with the American tech-driven economy shrugging it off — until financial market blowback hit with the “LTCM Crisis” in 1998 (a few months after I entered the financial industry). American tech investors have not fundamentally changed and they are not going to care about what happens to the rest of the world (or even the rest of the American economy). As such, there is no reason to expect that the financial market counterpart of the AI boom will lead global growth trends in a downturn, instead, weakness elsewhere would finally crack tech sector optimism.

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