Bond vigilantes are 'saddling up.' Here's how concerned investors might take action over the ballooning federal deficit.

• Bond vigilantes are "saddling up" again as federal deficits balloon, said market veteran Ed Yardeni.
• He coined the vigilantes term, referring to investors who sought smaller deficits by sending yields higher.

Bond vigilantes are getting ready to throw their weight around the Treasury market as the federal government's budget deficit is set to balloon, according to market veteran Ed Yardeni.

The president of Yardeni Research is famous for coining the vigilantes term in the 1980s, referring to traders who protested massive deficits by selling off bonds to push yields higher.

Now there are signs they are stirring again as bond yields continue to climb despite signs of cooling inflation. On Thursday, the 10-year Treasury yield hit the highest level since 2007.

That comes as the supply of Treasurys is expected to expand by $2.9 trillion this year and $2.4 trillion next year.

When asked on Bloomberg TV whether bond vigilantes are back, Yardeni replied, "I think they are. They're certainly saddling up."

He added that the bond market is typically driven by the outlook on inflation and the Federal Reserve's expected responses to it, with supply and demand for Treasurys usually less of a factor.

That's because federal deficits have historically widened during recessions while the Fed is cutting rates, Yardeni explained.

"This time around, we've got the federal deficit widening when the economy is doing well. And I think the bond vigilantes are quite concerned about that," he said. "There's way too much supply."

Yardeni expects the stock market to move sideways or continue to pull back this year on concerns about what the bond vigilantes will do.

By the end of the year, however, he still sees the S&P 500 rebounding to the 4,600 level and climb to 5,400 next year. "But I think in the short term, it's why the market has been down since the end of July."

The perceived power of bond vigilantes was famously illustrated in the early 1990s, when US yields jumped as investors dumped Treasurys amid fears about federal deficits in what became known as the Great Bond Massacre.

James Carville, who was an adviser to President Bill Clinton at the time, mused that he would like to be reincarnated as the bond market: "You can intimidate everyone."

In fact, Yardeni has described the 1990s as the heyday of bond vigilantes. During the Clinton administration, which worked with a Republican Congress, deficits shrank and yields fell.

But the roots of the concept go back to an earlier era of deficits. In a now-legendary commentary from 1983 titled "Bond Investors Are the Economy's Bond Vigilantes," Yardeni warned, "So if the fiscal and monetary authorities won't regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets."

He later explained that bond investors weren't necessarily trying to regulate the economy but were merely following their financial best interest: "concern that inflation might erode the effective purchasing power of their bond investment returns."