Panic station: Inside the bond markets

The Independent:

There is an angry mob out there. Its shape is dimly perceived, but the terrifying shadows cast by its burning torches are clear enough. This is the bond market in full cry.


Its most aggressive participants even call themselves the 'bond vigilantes'. Across Europe and into the UK, governments cower, populations are told to brace themselves for painful cuts, and austerity is the order of the day. In the US, too, their proscriptions are moving up the political agenda. Fail to assuage the mob, we are told, and untold horrors await, nightmare visions such as the flying apart of the eurozone, the ruin of the British Government's finances, or the final collapse of the US dollar's hegemony.

We are in danger of submitting ourselves to policymaking by fear. A world created in the image of the bond vigilantes is a vicious, reactionary place, to be resisted rather than embraced. And remember this, above all: the bond market is not always right....

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Government debt in the West has not been so large, relative to countries' economies, since the aftermath of the Second World War, and there is no disputing the need to get it down. The debate is over how, and how quickly. The most obvious way is through big spending cuts, imposed early. But a few extra percentage points of economic growth could do more to reduce deficits than swinging the axe, so there is a counter argument that keeping government stimulus in the economy for longer will prove more effective. This is the argument for which the UK squabble over (a financially insignificant) £6bn in post-election cuts was a proxy.

The right way to have the argument is between thoughtful economists and policymakers. You won't get the absolutist tone used by some of the players in the Chicago pits, and their analogues that pop up in the television studios of Europe.

The numbers are the numbers, you might hear – as if the numbers were something fixed. Actually, the numbers are just the outcome of a million assumptions plugged into a trading firm's economic mode, and how the traders act on the numbers involves lashings of emotion too.

If there's one lesson that we have learned from the market gyrations of the past few years – whether it be the slow-motion boom and sudden bust of the Noughties housing and credit bubble, or the "flash crash" of the US stock market that lopped 1,000 points off the Dow Jones in the space of 20 minutes last month (only to put most of them back on again before the end of the day). It is that markets are prone to swing too far in each direction and generate their own self- reinforcing feedback loops. Some of the traders at the CME know this, too. They know why it happens, and they fear it is happening too often. For all the bustle of its pits, the CME has greatly expanded what used to be a side line: the electronic trading of derivatives. Now, 75 per cent of this much-increased volume of activity bypasses the floor entirely. As well as providing new ways for investors and speculators to do business, it has opened up the market to even more hedge funds and others who use computer programmes to try to predict the markets. As often as not, these programmes exacerbate moves in one direction, and make it harder for other traders to resist any gathering momentum. As Ron Pankau puts it, "Many times during the day, the market doesn't make any sense."

Add into this brew the invention in recent years of even more derivative products – credit default swaps – so new that they have not yet started to be traded on an exchange and instead exist only between banks. Here is another way for speculators to increase the size and speed of their bets on government debt. We are in a dangerous world when the price of a CDS is being quoted on the news as if it is the official share price of a government. When Greece's financial woes became evident, speculators rushed to place CDS bets on Italy, Portugal and other eurozone countries, encouraging a climate of fear, spurring governments to bigger budget cuts and ultimately triggering the "shock and awe" announcement of a $1 trillion European Union bailout fund. The numbers that will genuinely count are the numbers for economic growth, for tax revenues and government deficits, and for the interest rate at which real buyers of real government bonds are willing to invest when new government debt is issued – real buyers who are investing for the long term, not for days or minutes.

So far, on all these measures, the world economy has performed consistently more strongly, and (with only a handful of exceptions) government bond auctions have seen consistently more demand, than the militants of Chicago have predicted. The power of the vigilantes has grown, no question, but not as much as might be imagined. The bond market rampant can burn down houses, and we must be wary, but there is no need to surrender pre-emptively to this modern form of mob rule.