Analysis: U.S. bond vigilantes in no mood to gun down deficit

By Ross Kerber

BOSTON (BestGrowthStock) – The so-called bond market vigilantes who in the past drove up U.S. bond yields and forced the government into more conservative budget policies are holding fire this time around.

For now these influential – and at times feared — investors seem to have concluded the U.S. economy is still too weak and deflation too much of a danger to tackle the budget deficit right away.

Prominent economist Ed Yardeni coined the term “bond vigilantes” in 1984 to describe why major investors were demanding higher yields to compensate for perceived risks of rising inflation as a result of large deficits.

But in recent interviews, some major bond fund managers say huge deficits are less of a worry in the short term than maintaining spending to keep the world’s largest economy from falling back into recession.

“Something needs to be done. But not right now,” said Ken Volpert, who oversees about $300 billion of bond assets at Vanguard Group Inc in Pennsylvania.

Such sentiments are a change from past U.S. economic debates when bond managers played the part of deficit hawks, selling bonds and sending interest rates higher while urging Washington to cut back on spending or risk sparking dangerously high inflation.

Washington financial blogger Stan Collender described the shift this month, titling a post that “Bond Vigilantes Are Now Deficit Cheerleaders,” and noting plunging interest rates.

A number of major bond managers say they are comfortable with congressional votes to continue spending on programs such as extended unemployment benefits.

Conversely, most spoke of the need for long-term cuts to government spending or fixes to make programs like Social Security and defense spending more sustainable for the long haul.

WITH ECONOMY WEAK, A VIGILANTE CONUNDRUM

If not cheerleaders, some managers at least are skeptical of quick deficit fixes.

Tom Carney of Weitz Short-Intermediate Income Fund (WEFIX.O: ), with assets of $900 million, said that it is not clear just what steps the federal government should take soon to curb spending without undermining the anemic recovery.

“I can understand the seeming consensus that it’s too early to draw it back,” he said of stimulus efforts. But the situation, he added: “leaves us with this conundrum of when, and how, to cut.”

The comments mirror the confusion felt by many economists and officials seeking a balance between encouraging growth and controlling deficits, following the most severe economic downturn in a generation.

Broadly, Democrats in Washington have cited economic arguments for keeping money flowing to various aid programs as a way of boosting demand lacking from the private sector.

Republicans have hammered at rising federal deficits — recently forecast to reach over $1.3 trillion for 2010 by the Congressional Budget Office, or 9.1 percent of gross domestic product — and how investors may react to the numbers.

Collectively, however, the bond managers seem to be content to wait and see how the economy develops.

“Right now the bond vigilantes have given carte blanche to the government to keep on spending,” said Yardeni, president of the advisory firm Yardeni Research.

The rare evidence of “vigilantism,” he said, has been in Southern Europe where yields have risen and governments have embraced austerity.

In the United States., however, rates have fallen of late, with 10-year Treasuries yielding roughly 2.5 percent, down from a peak of 3.9 percent in the spring and approaching the lows near 2 percent at the depths of the financial crisis in 2008.

The low rates have prompted some managers to sell, including Jeffrey Gundlach, chief executive of DoubleLine Capital in Los Angeles, which now has $4.8 billion in assets.

Gundlach said the U.S. government should consider new tools to promote job growth, such as tax breaks for new hiring, and may have to embrace bigger changes like adopting a value-added tax, as in Europe.

Another investor underweight in U.S. Treasuries is David Rolley, co-portfolio manager of Loomis Sayles Global Bond Fund (LSGBX.O: ), who helps oversee $25 billion. Rolley said he worries more about long-term issues. Spending cuts and new revenue sources ought to be considered, he said, like new taxes such as on gas or carbon emissions.

“What the market wants is clarity on tax policy, uncertainty reduction, and a plan to shrink the deficit over time and in the future,” Rolley said.

One fund manager more worried about short-term deficit spending is Rob Arnott, chairman of Research Affiliates in California. But Arnott thinks his views are in the minority, and added that interest rates may well stay low for a while.

“You can be a bond vigilante and take the view that now is the time to spend the money,” Arnott said. “I don’t take that view, but I respect it.”

(Reporting by Ross Kerber; Editing by Jennifer Ablan, Ros Krasny and Andrew Hay)

Analysis: U.S. bond vigilantes in no mood to gun down deficit