UBS: Complacency Will Be Tested As Bond Vigilantes Make Governments Pay For Their Sins

Harken back to 1994, where in a kind of economic protest of expansionary government spending, investors sold off bonds to raise yields, thus increasing the net cost of borrowing.

When these "bond vigilantes" felt as though policy was inflationary in nature, they just went ahead and ditched bonds, effectively stifling the government's ability to over-spend.

The Clinton White House was forced to abandon its stimulus plan. Yields returned to normal.

So when the Fed launched quantitative easing in the wake of the crisis, some observers warned we would see the bond vigilantes back protesting perceived inflation as the Fed flooded the financial system with liquidity.

They never showed up, according to UBS economist Paul Donovan. "The threat of 'implement plausible policies or we won’t buy your bonds' was itself implausible, when confronted by the lack of alternative investment options," Donovan wrote to investors this week.

Now, as the Fed begins to outline how it will scale back QE, market expectations are shifting. And bond vigilantes may have a role to play, governments beware.

From Donovan:

Emboldened by a sense of the power of policy and the persistence of market failure, governments have pursued a wide range of policies – some valid, some subject to criticism. The inability of markets to chide politicians for unwise policies has, perhaps, encouraged a sense of complacency in government circles. With global circumstances altering, that complacency is likely to be tested, as bond market vigilantes seek retribution for past as well as for current sins.

Donovan admits, however, that many investors are required by regulation (or encouraged) to own government bonds, limiting the power of bond markets to reprimand governments.

Still, Donovan argues many governments' policy errors were never rebuked in the market thanks to extraordinary financial circumstances. Now markets can afford to be more critical.