3 Ways to Pacify the Bond Vigilantes

After remaining very low for the better part of 2010, interest rates have begun rising. Treasuries yields and mortgage interest rates are both popping. While there are likely several reasons why this is happening, one could be that investors are worried about the U.S.'s unsustainable deficit path. The gigantic new tax cut package might be worrying so-called "bond vigilantes," investors who demand a higher default premium as the U.S. debt grows uncontrollably. If they're really driving the increase in interest rates, how can we pacify them so that rates don't continue to climb?

For starters, it's important to point out that the rise in rates might not be caused by investors fearing U.S. deficits. They didn't appear to mind big deficits so much throughout 2010, so it's a little surprising that they would suddenly be so concerned after the Bush tax cuts were extended. While it certainly made the deficit larger, it also provided more certainty that the U.S. would avoid a double dip recession. But since the tax cut compromise was announced, interest rates have definitely risen. If the vigilantes are driving the increase, then there are a couple ways to calm their fears.

Pass Proactive Tax Reform

When the new Congress convenes in January, tax reform should be a priority. Obviously, taxes are pretty set in stone for the next two years, but after that time, some big changes could be made -- and planned now. Government revenue needs to rise, at least for some years, until the debt can be paid down to a more sustainable level. If Congress puts tax reform at the top of their agenda, then bond investors would likely breathe a sigh of relief.

Pass Proactive Spending Reform

Of course, taxes are only one way to fix budgetary woes. The other would be to pass some spending cuts. Like with taxes, it's probably best if these cuts don't have much impact for a few years -- until a more robust recovery is underway. But once the economy is stable, Congress needs to use a machete, not a scalpel, to reduce its spending. Few programs should be left untouched, and entitlement reform needs to be a major party of the effort. Again, these changes might not take effect for some time, but discussion needs to get underway immediately to pacify the vigilantes.

Gridlock They Can Believe In

The fact that a big tax cut package passed might not really have been what scared bond investors. Instead, the process by which it succeeded might be what's got them really worried. For some time, we've known that there would be a shift in Congress due to midterm elections. As a result, some form of gridlock was expected -- even if that merely meant weaker Democratic majorities in both chambers of Congress making aggressive legislation less likely.

But President Obama's willingness to compromise with Republicans may be interpreted as a threat to gridlock. And if there's anything we know, it's that markets love gridlock. Less political risk means that business can carry on without having to worry about Washington's meddling. But if the President is willing to play ball with Republicans, then bills might actually pass for the next two years, instead of a period of stalemate where neither party is willing to sacrifice their ideals. Such compromise leads to exactly what we saw with the tax package -- even more spending than if either party had got just what they wanted and nothing else. After all, President Obama's demands added hundreds of billions of dollars in additional spending to the package beyond what Republicans wanted.

Of course, the exception to the desire for gridlock would be bills that seek to reduce the deficit, as explained above. But if Republicans and Democrats can agree to compromise, and spend more together than they would separately, then the bond vigilantes will not be amused. The only way to calm their fears would be for Congress to pass tax hikes, spending cuts, and little else.