Bond Traders: Still the Wizards of Oz?

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In the morning–primarily during an election season–I’ll watch Morning Joe. It’s a morning show structured as a series of discussions with a list of guests during the course of 3 hours. You often feel as if you’re in your living room absorbed in a thoughtful conversation with folks in the industry.

The host Joe Scarborough will occasionally wax poetic about Manchester United. If you’re like me, you aren’t very familiar with English Soccer (I mean, Football). Nevertheless, Joe’s emotions can be so infectious that I can’t help but join in and cheer or feel exasperated with him.

There are quotes in our history that address a topic so deep in the pocket that on the surface, folks may not immediately understand what the quote really means. Nevertheless, the emotion behind the delivery may sway someone to feel one way or the other without necessarily understanding why.

Case in point: Former President Bill Clinton’s famous quote about bond traders. According to Bob Woodward in his book The Agenda, President Clinton’s plan to spur economic growth with federal spending was turned on its head when he learned that sentiment in the bond market against an increase in federal debt could neutralize economic growth.

Clinton responded by saying “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 *($&ing bond traders?”. It was as if Clinton realized that the bond traders were the Wizards of Oz, secretly in control of the US economy somewhere behind a curtain over the rainbow.

Clinton’s emotion was directed at the fact that at the time, the interest rates may be kept high by bond traders despite his economic strategy to spur growth. For comparison, the rate on a 10-year Treasury bond in 1993 was almost double what it is today.

Interest rates in a country’s economy are a reflection of whether that economy is seen as a safe investment. As with all loans (which a bond effectively is), the interest rate on the loan is directly related with the entity’s apparent ability to repay the loan.

A high interest rate may imply that the entity may not be trusted to repay the loan. So in exchange for the risk of lending money to that entity, the lender receives a high interest rate to compensate for taking the risk.

In today’s world, Greece has witnessed a rapid rise in bond yields as private investors have largely shunned Greek bonds on fears that the Greek government will eventually default. A rise in the effective yield on a bond is paired with a decrease in market price. As a result, the unlucky existing holders of a bond whose yields have risen in the market will either need to sell their bonds at a loss or keep their capital tied up until they’re able to recoup a reasonable chunk of the original loan.

As a result, these private investors may not invest in job-creating ventures in the economy if their money is tied up. This includes buying municipal bonds to loan money to cities and states to build infrastructure, invest in education, and more.

In short, high interest rates have negative implications on an economy. It’s synonymous to your attempting to get a loan from a bank with bad credit and a spotty job history, and being presented with a high interest rate on your loan.

While interest rates in the US have stayed extremely low despite a sharp increase in federal spending to stave off an economic collapse in 2008, one has to feel the threat of Greece’s situation of being saddled with a spike in interest rates and a decline in investor interest.  As a result, it’s smart to keep an eye on sentiment in the bond market as US debt increases, and to not assume that they’ll be kind if we peek behind the curtain.