'Bond Vigilantes' Push Italy, Spain Interest Rates Higher - is U.S. Next?

If you get the sense that Democrats and Republicans in Washington still don't get the message, you're not the only one. It's as if the Democrats and Republicans in Washington aren't watching events in Europe related to Italy and Spain, following events in Greece.

Institutional investors have already imposed a risk premium on Italy and Spain -- they've increased the interest rate that each has to pay to borrow money in credit markets for short-term debt.

Italian Auction: So-So

Italy sold €3 billion ($4.1 billion) of 10-year notes due September 2012 at a yield of 6.29 percent -- the highest interest rate since June 1997 and higher than the previous auction held on Oct. 13, Bloomberg News reported Monday. Demand increased to 1.47 times the amount of the offering, up from 1.34 times in October.

Meanwhile, the Spanish spread over German bunds for 10-year notes increased 36 basis point to 432 basis points with the yield reaching 6.74 percent -- the most since 1998.

Why is this important for the U.S. and for American taxpayers?

Presently, the U.S. government can borrow money for 10 years at about 2.05 percent. Up to now, institutional investors have been patient regarding the nation's effort to decrease, then eliminate, its large budget deficit, which the Congressional Budget Office estimates will total $1.10 trillion in fiscal 2012, the current fiscal year, and $704 billion in fiscal 2013, next year.

However that Institutional investor patience could change, in a hurry.

Bond Vigilantes: Who Will They Hit Next?

The bond vigilantes among the institutional investor camp could, for any number of reasons, suddenly decide that U.S. Treasury bills -- up to now the safest bond investment in the world and one of the safest investments overall -- aren't the best place to park their money.

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.

The bond vigilantes could decide that Washington -- its hopes riding on Congress' super committee -- isn't serious about deficit reduction, long-term, and that the U.S. will continue to run plus-$600 billion deficits through the end of the decade.

At that point, the pain could start. The discount--or the reduced interest rate that investors charge the U.S. government--would end, the bond vigilantes would be dominant, and U.S. interest rates would move higher.

Translation: If the bond vigilantes attack, the U.S. government's cost of servicing its debt would soar, perhaps to levels that are too high, assuming current funding levels of government commitments, such as national defense, Social Security, Medicare, senior citizen prescriptions, and Medicaid.

As a result, Congressional officials would then be left with the difficult choices of either a massive cut in spending or a massive increase in taxes. Or an onerous combination of the two.

And, needless to act, if the bond vigilantes attack, the dollar, already pummeled by a decade of deficit spending in 2001-2008, would take another hit, reducing the value of dollar-denominated investments.

Hence, it goes without saying that it's time for Democrats and Republicans in Washington to quit the posturing and pass a substantive, enduring deficit reduction package - one that cuts the deficit long-term, and that includes a tax increase as well as a large spending cut. The bond vigilantes are watching.