The ensuing run-up in long-term interest rates raised borrowing costs, and many economists believe stunted the recovery. It took the New Economy's productivity boom to finally break the vigilantes' hold on the bond market by showing that low inflation and fast growth could co-exist.
Now, with the economy again reviving from recession, long-term interest rates are once more on the rise. The yield on the key 10-year Treasury bond has soared to a nine-month high of 5.4%, while the rate on 30-year mortgages has jumped to 7.18%, from a low of 6.45% last fall. So far, the rise in rates has been largely benign for the economy, representing a return to normality in a market that was thrown into turmoil by the terrorist attacks on September 11.
RISING EXPECTATIONS. Some worrying signs, however, indicate that the long-term rate rise could get out of hand. Just as they did in the early '90's, investors are beginning to fret about a pick-up in inflation. Some question the Fed's determination to control it by manipulating short-term rates. "There has been a big increase in inflation expectations," says Tony Crescenzi, chief bond market strategist at broker Miller Tabak & Co.
In fact, real long-term rates are more than 4%, well above the average of 3.4% over the last decade. If the Fed can't assuage the market's nascent concerns about inflation, long-term rates could rise further, undercutting the stock market and stifling the economy in the process.
No reason to panic just yet, though. Treasury bond yields fell to abnormally low levels last fall, as investors flocked to the security of U.S. government debt in the wake of September 11. Some rise in yields was inevitable, as investors became less risk-averse. And that's good news for the economy.
PERCOLATING FEARS. Rather than plowing their money into ultrasafe Treasury bonds, investors are now shifting funds into the stock market and corporate debt. Corporations have taken advantage of the investors' increased tolerance for risk to restructure their balance sheets and replace undependable short-term borrowings with long-term debt. According to John Lonski, chief economist at Moody's Investors Services, U.S. companies issued $53.1 billion of investment-grade bonds and $9.6 billion of high-yield debt through the first three weeks of March. That was up from $47.7 billion and $5.8 billion, respectively, in February.
Inflation fears are starting to percolate in bond land, however, posing risks for the economy and the Fed. The yield spread between Treasury inflation-indexed bonds and conventional government debt -- a proxy for inflation concerns -- has widened by more than 50 basis points this year, to over 2%. Although that's still modest, it's significantly higher than current year-on-year consumer price inflation of just 1.1%.
Another sign of investor unease with the Fed: The yield on two-year Treasury notes has soared to more than 3.5%, well above the 1.75% target the Fed has set for the overnight interbank rate. The spread between the two is the widest it has been since 1995 -- and a signal that investors believe Fed policy is way too lax.
"WE'VE WON THE WAR." Central bank policymakers have tried to convince the markets not to worry about inflation. On Mar. 26, New York Fed President William J. McDonough told business economists the U.S. had achieved the Fed's long-sought goal of price stability and that inflation might ebb even further this year.
So far, investors don't seem to be buying that line. Based on the bets they're making in the futures market, investors think the Fed has to raise short-term rates by as much as 150 basis points this year, starting at its next meeting on May 7. "We've won the war against inflation, but the market hasn't accepted that," says Paul A. McCulley, managing director of major bond investor Pacific Investment Management Co.
That could be a big concern. If the bond vigilantes are indeed back, that migh spell trouble for the markets and the economy. "They've got the rope in their hands, but they haven't tightened the noose yet," says Brian Wesbury, chief economist at broker Griffin, Kubik, Stephens & Thomson in Chicago. For the sake of the recovery, better hope it stays that way. By Rich Miller in Washington