Janet Yellen and the man who invented the term ‘bond vigilantes’ disagree about what’s happening in the Treasury market right now

Yardeni coined the phrase “bond vigilante” in 1983 to describe investors that sell Treasuries in order to either protest against or influence monetary or fiscal policy. And in a video webcast on Wednesday, he warned that these bond vigilantes are now back in force. “Not only are they saddled up, but they’re on the move,” he said.

According to Yardeni, some bond market investors aren’t happy with the compensation they’re receiving for holding U.S. Treasuries owing to the increased risk of persistent inflation and the rising national deficit, so they’re selling them in droves and pushing yields higher. To his point, the yield on the 10-year U.S. Treasury note has jumped from roughly 3.3% at the start of April to over 4.7% today. And this was not only the result of the Federal Reserve’s interest rate hikes, but also because many investors and banks have sold off or refrained from purchasing U.S. debt.

But Treasury Secretary Janet Yellen pushed back against the idea that the bond vigilantes of the past have returned to the U.S. to influence fiscal or monetary policy at Fortune’s 2023 CEO Initiative this week, arguing that the dynamics that brought out bond vigilantes decades ago don’t exist today.

The former Federal Reserve chair described how she first heard of the term bond vigilantes in the early 1990s, when inflation was relatively high and interest rates were rising. During that period, the 10-year Treasury yield surged, implying that the bond market believed the Fed would be forced to continue raising interest rates to tame inflation. 

It was such an epochal moment for the rough riders of the bond market that Bill Clinton’s communications guru James Carville famously summed it up in a 1993 speech: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would want to come back as the bond market. You can intimidate everybody.” Around the same time, Clinton appointed Yellen to serve on the Federal Reserve, and she joined his Council of Economic Advisors in 1997.

The reason this debate matters (and that the endlessly quotable Carville weighed in on it) is that the dreams of central planners and economists can easily be broken on the back of an unruly bond market. As a mass of traders take matters into their own hands and push Treasury yields ever higher, the costs of borrowing for businesses and consumers alike increase, weighing on economic growth in a similar manner to rate hikes from the central bank. And in the climate of 2023, coming off the fastest series of rate hikes in over 40 years, rising bond yields are a double whammy for an economy that is still fighting off a long-predicted recession.

But Janet Yellen doesn’t think that’s what’s going on at all.

How Yellen sees it

The concern that Yellen recalled from the 1990s, she told the Fortune conference, “was that the bond markets were driving the Fed’s behavior, and that they would continue pushing the Fed [to raise interest rates] to the point where the economy would fall into a recession.” But she emphasized that she doesn’t “honestly think that that’s the case” today.

Yellen believes investors are simply trying to discern what interest rates central banks worldwide will need to maintain to ensure inflation doesn’t rebound. If anything, in her view, the recent spike in the 10-year Treasury yield is a sign of the economy’s resilience in spite of rising interest rates, not a protest against fiscal or monetary policy by bond vigilantes.

She argued that the bond market is reacting to strong consumer spending and a stabilizing housing market. “The economic resilience that they [bond investors] see may suggest higher for longer [interest rates],” she said, arguing that may be why the 10-year Treasury yield has surged this year. “But we’ll see.” 

Yardeni’s view

Ed Yardeni has a very different take on why bond vigilantes have returned this year. 

“What the bond market is really concerned about—what the bond vigilantes are concerned about—is profligate fiscal policy,” he said. “It may very well be that the bond vigilantes are shouting to the fiscal authorities, ‘No más, no more. You gotta do something about these out of control deficits.’” 

To his point, the U.S. national debt has soared 43% from $23.2 trillion in the first quarter of 2020 to over $33.4 trillion today owing to an unbalanced federal budget. And through the first nine months of this year alone, the national deficit reached $1.52 trillion.

Yardeni, who remains steadfastly bullish about the future prospects of the economy and the stock market, warned that bond vigilantes are seeking to increase the yield of the 10-year Treasury to compensate for the now much greater risk of holding U.S. debt. But it’s not just these bond market leaders driving the 10-year yield higher—the Fed is also to blame.

For years after the Great Recession, and particularly during the pandemic, the Fed engaged in a somewhat controversial policy called quantitative easing (QE) where it would buy governments bonds and mortgage-backed securities in order to spur lending and investment in the economy. But in April 2022, with inflation surging toward a four-decade high, the central bank decided to reverse that long-running policy and began a process called quantitative tightening (QT), which slowly reduced its holdings of government bonds and mortgage-backed securities. 

This trend can be seen in the Fed’s balance sheet, where it holds these debt securities. When the pandemic began in February 2020, the Fed had $4.1 trillion in assets on its balance sheet. But by April 2022, that number surged to a peak of nearly $9 trillion owing to QE. Then, QT began, and the balance sheet shrunk to roughly $8 trillion in assets in just 17 months.

All of this means the Fed is holding fewer Treasuries, which has increased their supply at a time when bond vigilantes are out in force, lowering demand for all U.S. government debt. As Yardeni explained, “The Fed isn’t helping” the supply and demand dynamics in the market.

“So I think what we’re seeing here is the bond vigilantes protesting profligate fiscal policy,” he said. “And the Fed is selling or letting mature its bond portfolio.”

Yardeni said that eventually Treasuries will find buyers from U.S. households and internationally despite the increased supply caused by QT and a lack of demand owing to bond vigilantes. But the question is, what yield will those buyers require in compensation for the increased risks of holding U.S. debt amid higher inflation and a seemingly unsustainable fiscal policy?

“The bond market is answering that for us on a daily basis,” Yardeni concluded, warning that hedge funder Bill Ackman’s prediction of 5% or 5.5% 10-year Treasury yields may end up coming true sooner rather than later.