'Bond Vigilantes' Could Trigger U.S. Sovereign Debt Crisis

Greece, the tiny Mediterranean nation plagued by sovereign debt problems, still bears watching by U.S. investors/readers.

And the reason? It appears the global financial system has not rid itself of 'the attack of the bond vigilantes.'

Lehman Bros., Greece, Who's Next?

Economist Ed Yardeni, who now runs Yardeni Research Inc. of Great Neck, N.Y., coined the term 'bond vigilante' in the 1980s to describe the institutional investor practice of selling bonds and shorting bonds of governments when they see unsustainable fiscal policies and/or other actions by governments or companies that the institutional investors believe will lower the value of the bonds issued.

Further, the decline and fall of financial giants Bear Stearns and Lehman Brothers, although without question rooted in dubious, high-risk business practices and extreme leverage, were nonetheless pushed to quicker demises by the bond vigilantes. In the financial crisis that reached its acute stage in the fall of 2008, they shorted those infamous subprime mortgage-backed securities, many of which were vastly overvalued prior the waves of vigilante selling and shorting.

Now it's the selling/shorting, and in some cases the failure to 'rollover' investments in sovereign debt -- the bonds issued by the debt-plagued governments of Greece, Portugal, and Spain, among others.

European officials are hopeful their expanded emergency fund will be able to both stabilize Greece and stop contagion -- in effect fight and check the bond vigilantes.

But will the emergency fund be enough? It probably won't be, and more action will be needed. The yield premium - the extra interest rate that lenders are demanding to lend to Greece, Portugal, and Spain, as opposed to low-risk Germany - continues to be too high.

Is Washington Listening?

The relevance of the above is duofold for the U.S. investors/readers.

First, Greece matters. Although Greece is a small country with an equally-modest economy, 2010 GDP of $305 billion, Greece is not an insignificant credit market participant. Germany and France have a loan exposure of more than $400 billion to Greece, hence if their banks are hurt by losses on Greek bonds/loans, that would almost certainly lead to an increase in interest rates in Europe, and the United States, including home mortgage rates. The average 30-fixed rate, currently 4.55%, would rise to about 4.75-5%, and probably higher in a few months.

Second, Greece serves as yet another warning to the United States to eliminate its budget deficit by reducing spending and raising taxes.

If the United States doesn't, it fails to do so only at its own economic peril, and the reason is obvious enough: for now the bond vigilantes have not turned their sights on the U.S. high-debt condition. In a nutshell, they've cut the U.S. some slack because of its global reserve currency status, among other factors. Again, the bond vigilantes have not focused on the U.S., for now.

But that could change.