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CNN
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In early 1993, President Bill Clinton tried to push through the economic stimulus package he had announced on the campaign trail.
But these promises were stopped in their tracks by a formidable opponent: the bond market.
Clinton was forced to abandon much of the economic plan and shift focus to fixing the budget rather than risk raising interest rates that would shock the economy.
That episode showed the power of the bond market to control policies with which investors disagree — even those backed by a president emboldened by a political triumph.
Clinton political adviser James Carville said at the time: “I thought if there was going to be reincarnation, I wanted to come back as the President or the Pope or a .400 baseball player. But now I would like to come back as the bond market. You can scare everyone.”
The bond market can be so intimidating that in the 1980s, economist Ed Yarden called these indignant investors “bond vigilantes” for their role in maintaining law and order in the capital markets if government officials fail to do so.
Now there is the risk of another clash between those bond watchers and a newly elected president.
Even before President-elect Donald Trump takes office, the bond market is already flexing its muscles. Yields have risen to uncomfortably high levels due to a confluence of factors that include worries about high budget deficits and the risk that Trump’s tariffs, tax cuts and deportations could reignite inflation.
“We’re in a déjà vu moment,” Yardeni, president of investment advisory Yardeni Research, told CNN in a phone interview. “Trump did not automatically win the vote of bond vigilantes. He has to earn their respect.”
If he doesn’t, the bond market could act as a brake on Trump’s policies. And that would be painful, especially for a president who sees the stock market as a real-time barometer of his success.
After Friday’s jobs report, the bond market sold off again. That pushed 10-year US Treasury yields closer to the 5% level that many see as a dangerous red line.
The higher rates rise, the more pressure they will put on stocks. After all, if ultra-safe government debt is returning 5%, expensive tech stocks look less safe by comparison.
Not only that, a potential selloff in the bond market would make borrowing more expensive for businesses and consumers, raising mortgage rates and other debt.
That would undermine Trump’s promise to lower the cost of living for Americans.
Higher Treasury rates, by definition, would also make it more expensive for the federal government to finance its mountain of debt. That’s a problem because interest already eats up a larger share of the annual federal budget than defense spending.
“Bond vigilantes haven’t been heard from for a long time. But they’ve only gotten more powerful,” Yardeni said, noting that America’s growing debt makes the budget more sensitive to even modest rate changes.
And higher rates could force the Federal Reserve’s hand, prompting officials to raise their benchmark short-term rates to prevent the economy from overheating.
“This is a nightmare on top of a nightmare,” Yardeni said.
It’s important to note that Trump is inheriting a very different economy this time around.
When Trump won in 2016, the economic recovery from the Great Recession was disappointingly mediocre. Interest rates were still extremely low. And central bankers were worried that inflation was too low.
Now, the economy is firing up, with gross domestic product, job growth and inflation all surging to the top.
Mainstream economists have warned that Trump’s agenda could be inflationary, perhaps too inflationary.
Not only that, but the deficits are much higher now.
“Trump 1.0 and Biden put the next administration in,” Yardeni said, “because the bond market will prevent them from being able to run reckless deficit policies.”
Some on Wall Street are worried that if policymakers are not careful, the United States could face its “Liz Truss moment.”
In 2022, bond investors rebelled against British Prime Minister Liz Truss’s budget proposals. It was such a disaster that Truss was forced to resign, becoming the UK’s shortest-serving prime minister.
Scott Bessent, Trump’s nominee for Treasury secretary, is well aware of bond vigilance. Bessent, a widely respected investor with deep experience in the markets, expressed confidence that Trump can reduce the budget deficit.
“Bessent is a prince of those relationship vigilantes. Now he is in the chair as secretary of the Treasury. He knows how to play chess against those other players in the market,” said Ed Mills, Washington policy analyst at Raymond James.
Questions on deficits and tariffs
But it will not be easy to reduce the deficit, especially because there is not much room to cut spending. Most of the federal budget is tied to interest payments, defense spending, and social safety net programs that are politically popular.
Even Elon Musk has reneged on his earlier promise to cut $2 trillion from the federal budget, a figure many experts have deemed unrealistic.
Considerable uncertainty remains over the tariffs, including when they might be imposed, how high they will rise and how long they will be in place.
Tariffs can raise revenue, but they can also stifle growth.
“Tariffs are a double-edged sword. They can raise incomes, but they can be harmful to growth because they trigger retaliation from other countries,” said Ernie Tedeschi, director of economics at the Yale Budget Lab and a former chief economist at the House Council of Economic Advisers. White under President Joe Biden.
Another major question is whether Trump will go beyond extending the tax law that expires in 2017 by enacting new tax cuts.
On the campaign trail, Trump pledged to end taxes on overtime, tips and Social Security benefits and enact other holidays.
Trump also promised to address complaints about the $10,000 limit on state and local tax deductions (SLT) that were part of the 2017 law. The salt cap hurt upper-middle-class Americans in high-tax states.
Tedeschi said Republican efforts to scrap the salt cap and enact other tax breaks could provoke a response from bond investors already worried about the deficit.
“Bond traders would personally like to remove the SALT cap. But it would be extremely expensive and worsen our fiscal trajectory,” he said.
Seema Shah, chief global strategist at Principal Asset Management, agreed that investors are worried about the deficit widening if it doesn’t accelerate long-term growth.
“You can’t add that much stimulus at this point because inflation is high and the deficit is high,” Shah said.
Yarden hopes that the presence of bond vigilantes and Trump’s focus on the stock market will act as a powerful veto on risky policies, preventing them from becoming a reality.
“If yields rise, the stock market could fall, and the administration will respond quickly because Trump sees the stock market as his daily popular vote,” Yardeni said. “That’s the power of link watchers.”