The Bond Vigilantes vs. Trump's Economic Chaos

I recently wrote about a somewhat mysterious group of financial traders known as the bond vigilantes. Their actions caused Donald Trump to abort many of his Liberation Day tariffs, but that does not make them the good-guy defenders of democracy. In fact, they are quite the opposite.

Many understood that point, thankfully, but others wondered about the government bond market, how it worked, and why the value of something fully backed by the faith of the U.S. government might be mutable in value.

Readers had questions and the answers will help us understand why Trump flinched when the bond vigilantes drove up the interest rates on government bonds. As we shall see, what seems like a small change in interest rates has a very big impact on the value of outstanding bonds, causing the loss of trillions of dollars in a flash.

Warning: Do not use Google to research bond vigilantes. When I did so, its Gemini AI function hallucinated and used my article from last week as a source!

Let’s start with the basics:

Q: What is a bond?

A: When you buy a bond, you are making a loan to the issuer-- a government, a bank, a corporation. You give the institution your money and they agree to pay you back on a certain date, plus interest. The interest is your incentive for loaning your money.

How much interest you get for loaning your money depends primarily on two things: 1) How likely is it that the borrower will be able to pay you back; and 2) The overall rate of inflation. Interest payments should be above the current and expected inflation rates, because if you were paid less for your loan, you would be losing money in terms of purchasing power.

Q:What is the bond market?

A: It’s a big market, the biggest in the world, even bigger than the stock market. There are $140.7 trillion worth of outstanding bonds in the market, compared to $115 trillion worth of stocks. The bonds are traded just as stocks are traded, with investors buying and selling depending on their analysis of the market’s future performance.

Q: How is a bond different than a CD?

A: There really isn’t any difference between a CD and a government bond except that a CD is issued by a bank and is guaranteed up to $250,000 by the Federal Deposit Insurance Corporation (FDIC). The interest rate for any duration of CD (whether six months or five years) will be comparable to the interest rate on government bonds with similar durations.

Corporate bonds come with more risk. Your loan is not guaranteed so there is a chance that a corporation that takes your money will not be able to pay you back – that’s called the risk of default. Because of the risk, the rate of interest you receive on a corporate bond will always be higher than a CD or a government bond.

You can make more money, but you can also lose more money. That’s your risk.

Q: Aren’t US Treasury bonds risk free?

A: Yes, provided that the U.S. government pays its bills, which apart from a few extreme examples it always has. And notably, the U.S. government has never defaulted on its obligations to repay treasury bond holders.

Since World War II, U.S treasury bonds have been considered the safest investment in the world. The 10-year treasury bond is used as the benchmark for many other forms of credit, including mortgages, car loans and corporate borrowing.

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Q: OK, I understand that a bond is a loan, and the interest I get is based on how risky that loan is, as well as how much inflation there is. But in your article, you said a $1,000 bond might be worth less than $1,000. How is that possible?

A: A $1,000 government bond has a face value of $1,000. On its maturity date, let’s say in ten years, it will pay you back $1,000. In that sense, it is always worth $1,000.

But each bond also has an interest rate, and as that changes, so does the value of the initial $1,000 investment.

Q: So how could it ever be worth less than $1,000?

Let’s say on Day 1 you buy a $1,000 bond with a 4.5 percent interest rate. If you hold onto that, you will be paid $45 interest per year and then get back your $1,000 principle ten years later.

Now imagine that inflation rises, and a new 10-year bond is issued by the government a year later. Instead of 4.5 percent rate the new 10-year bond has a 5 percent interest rate. Each year, a bond holder of the new issue will get $50 in interest payments on his $1,000 investment, while you’ll be getting $45.

Both bonds will still return $1,000 at maturity, but the more recently issued bond is paying more in interest each year.

If, another year later, you want to sell your 10-year government bond because you need the money to buy a dozen eggs, you won’t be able to sell your 4.5 percent 10-year bond for $1000.

The market sets the price, and because there are other bonds out there paying a higher interest rate, your bond with the lower interest rate will be valued at less than $1,000. Even though in eight years you’ll be able to cash it in for $1,000!

Q: Wait a second. You said my treasury bond is risk free and will always be worth $1000, but now you say it’s not? How does that work?

A: On the secondary market, your bond is worth what its interest rate says its worth. (The primary market is when the government sells the bonds. The secondary market is when everyone else can buy and sell existing bonds.)

Here we need to do some simple math. Your bond pays $45 in interest payments, but the new bond pays $50. Why would anyone want your bond if it pays less than the new bond? They wouldn’t.

But they would if you lowered your price so that your bond would pay out at the new going 5.0 percent rate instead of 4.5 percent.

Here’s how that works on the simplest level. For your 4.5 percent bond to pay out at 5.0 percent, the price would have to go down to $900. At $900 your bond would then be paying out at the new going rate of 5 percent: $900 x 5.0 percent = $45 per year.

The market is willing to buy your 4.5 percent bond after it becomes a 5.0 percent bond by lowering its price. (The actual formula for bond pricing is more complicated because it also accounts for the number of years, the number of interest payments per year, and anticipated interest rate changes over the years, but the basic principle is the same.)

Q: Well, my bond is worth $1000 and that’s what I want and that’s what I’m guaranteed to get!

A: Right, if you hold it until it matures. You will indeed get back your entire thousand dollars. But you will also have earned only $450 in interest, while more recently issued higher-rate bonds will have earned $500. Which is why, if you want to sell before your bond’s term is up, and other bonds are at 5 percent, you’ll only get $900 for your bond. That’s just the way interest rates and bond prices work.

Q: What happens if interest rates go down?

A: If interest rates go down, when you sell your bond before its term is up, you’ll get more than $1,000. The process is exactly the opposite.

You have a bond that pays 4.5 percent interest, and a new bond is issued that pays only 4 percent because inflation has gone down. The new bond pays $40 per year, while your 4.5 percent bond pays $45 per year. Clearly, your bond is more valuable than the new bond even though they both are $1,000 bonds and will pay $1,000 when they mature.

If you decide to sell your 4.5 percent bond, the secondary market will sync your bond to the value of the new 4 percent bond, which will increase the value of your principle to $1,125. That’s because $1,125*4.0 percent = $45.

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Q: Where do the bond vigilantes fit into all of this?

A: The idea of bond vigilantes was cooked up by an economist in the 1980s named Ed Yardeni. It’s a vivid image that evokes the citizens in old western movies putting together a posse when the sheriff is unable to administer the law on his own.

Bond vigilantes act as a posse administering capitalist law and order. They buy and sell bonds and currencies in vast quantities based on their analysis of what governments are doing or not doing to protect financial and corporate capital.

The vigilantes work for big banks, hedge funds, mutual funds, private equity funds, sovereign wealth funds and any place that has lots and lots of investment capital.

Unlike a posse, they are not an organized cabal. They work for different financial entities, but they are united by their world view. They react badly to any policies or programs they see as being inflationary or harming the interests of high finance or large corporations. They want governments to step away and let market forces determine the forward march of human history.

Q Can you give us an example of how they function?

A: Sure. Let’s look at George Soros and the British pound.

(The valuation of currencies is very similar to the valuation of government bonds. Both depend on the health and well-being of a country’s economy and credibility.)

In 1990, as Europe moved closer to a common currency – the euro -- it set up the Exchange Rate Mechanism as a clearinghouse for EU currency values. The ERM set the British pound at a fixed rate against the German mark, trying to eventually move the currencies to common ground. All well and good, but George Soros thought that the ERM agreement overvalued the British pound, meaning that Soros thought one British pound should be worth fewer German marks than what the agreement stated.

Soros was so convinced that the pound was overvalued that he went into vigilante mode and shorted the British pound.

Shorting means that he borrowed pounds from brokers and sold lots and lots of them at the current ERM determined exchange rate. (BTW, Scott Bessent, Trump’s Treasury Secretary, worked for Soros on this deal.)

Why would Soros do that? Because he was betting that the value of the pound was going to decline, correcting the ERM’s error, and he would then be able to buy many more pounds at a lower price, returning what he had borrowed earlier and pocketing the difference. Bonds and stocks can be shorted in the same way.

Soros was betting that the value of the pound would go down and it did. His mass selling of the pound was soon followed by other currency traders joining in, collectively putting a lot of downward pressure on the value because so many pounds were being sold in a hurry. The Bank of England saw the value declining and tried to protect it by buying pounds.

That created a currency tug of war, with Soros and others selling billions in pounds and the Bank of England buying up those billions. If the value of the pound held, Soros would lose his bet, but eventually the Bank of England gave up and the value of the pound went down.

Soros won his bet and made more than one billion dollars back when a billion dollars was a lot of money. The Bank of England gave up trying to defend the value of the pound and the United Kingdom had to withdraw from the European Exchange Rate Mechanism because the value of the pound had declined against the German Mark and broke the ERM.

Q: Is this what’s called a “run”?

A: Yes. A “run” is when a lot of traders (vigilantes), mobilizing a lot of money, bet against a currency, a bond, a bank, a stock, etc. trying to force its value down. They are betting that the value of the currency, bond, or bank or corporate stock will go down enough for them to cash out, before they need to cover their bets.

Sometimes, lots of very big players follow each other in attacking a currency, bond, bank, or stock. Together these vigilantes have enormous power to weaken their targets and make them do what the vigilantes want.

Q: What did the vigilantes do to Trump?

A: They put the hammer down on Trump’s on-and-off-again crazily unpredictable Liberation Day tariffs. They used their tools to sell lots of 10-year US treasury notes, driving down their price and thereby raising the interest rates on them. The vigilantes were saying that if you do all this crazy stuff, we want a higher interest rate for the money we and millions of others are loaning to you.

When they hammered the 10-year U.S. treasury bond, they threatened the entire economy. That’s because that 10-year bond sets the rates for other loans. like mortgages, auto loans, and corporate borrowing. If those rates kept rising as the vigilantes sold more and more bonds, the U.S. economy would likely head towards increasing inflation, unemployment, or both.

And as we saw from our simple example, what seems like a small rise in interest rates translates into a very big loss of principle. Trump folded as trillions of dollars of bond value in the largest market in the world, evaporated in a flash.

Q: I’m no fan of Trump and his tariffs, but who elected the vigilantes to veto the policies of an elected president?

A: No one and that’s a real problem. Rampant and unregulated trading almost sunk the economy in the late 1920s and early 1930s, and it was a complex series of banking and market regulations put into place by President Franklyn D. Roosevelt as part of the New Deal that saved the economy. For more than 40 years those regulations meant there were no banking crises, and we had a financial sector that didn’t reap runaway salaries.

The deregulation of Wall Street, starting in the 1980s or so, undid many of those safeguards and allowed high finance to move money around the world at will, increasing the power of financial markets over government policy. (I tell much of that story in Wall Street’s War on Workers.)

Bond and currency traders share a deep understanding of what is good for capitalist markets. When they see that a country is spending heavily on social programs or promoting stiff regulations on business, they are likely to place their bets against that country’s bonds and currencies.

Because money can be moved in and out of a currency or a bond just about instantaneously, the vigilantes, in effect, create capitalist discipline over nearly every country. The needs and wishes of capital face off against the needs and wishes of democracy, and so far, capital is winning.

With that toothpaste out of the tube after 40 years of financial deregulation, reining in capital is a Herculean task that may not be completed until there is another disaster on the scale of the Great Depression.

But letting capital run free and unregulated is proving to be a troubling idea that needs to be addressed. The very idea of democracy may hang in the balance.