When you hear the word “vigilantes” in financial markets, it’s usually referring to “bond vigilantes” the quasi-mythical creatures that drive interest rates up, and force governments and their central banks to either cut spending or tighten monetary policy.
The debate about the existence of vigilantes is tired, but it’s a useful term in the sense that some market movements do inspire policy responses.
In Europe, high rates for government borrowing have prompted all kinds of action on the part of official figures.
In the US it’s been ages since anyone cared about high interest rates, or saw them as a threat.
But the stock market is a different story, and there’s this belief that if the Fiscal Cliff situation got too bad, then the market would tank, and that would force a resolution.
Says BofA’s Ethan Harris:
Historically the bond market has been a disciplining force for policymakers. When the Fed was too soft on inflation or the fiscal deficit was out of control, interest rates spiked higher. In our view, this has changed and today the stock market is the disciplining force for Washington. Stocks have generally endorsed Fed policy. We estimate that stock prices rose a cumulative 15% in the past three years in response to Fed announcements or actions. While some investors have misgivings about what the Fed is doing, the overall market likes it. By contrast, the stock market is giving a clear no-confidence vote to fiscal policymakers. This was particularly clear when the TARP bailout plan failed to pass and at the end of the debt ceiling debate.
Today, the stock market “vigilantes” are gathering again. In early September we argued that “there is a high risk of a risk-off trade in the markets after [the Fed meeting on] September 13.” We argued that market focus would shift from Fed and ECB easing to fiscal policy risks. In the event the Fed meeting did mark a turning point in the markets, and with the election over and the fiscal cliff taking centre stage, the downward pressure has accelerated. This weakness has occurred despite better news on the economy and an unremarkable earnings season.
It’s possible that the latest market selloff is being over-fitted to the Fiscal Cliff negotiations, and that the relationship is weaker than assumed.
For one thing, there really haven’t been many signs of deep acrimony… certainly nothing like there was in the weeks/months leading up to hitting the Debt Ceiling. Furthermore, there have been other negatives facing the market. Furthermore, this downturn in the market has coincided with a decline in earnings optimism.
That being said, investors are clearly thinking about the cliff a lot.
Morgan Stanley’s Vincent Reinhart recently published this chart, asking investors how significant the issue was in their thinking/investing decisions.
Less than 10% of respondents didn’t think the Fiscal Cliff was an important consideration in making decisions.
So for folks hoping for a decent resolution, it’s hopeful that there’s some kind of feedback going on, where investors can pressure policymakers into defusing the bomb.
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