Bond Vigilantes Push Up Italy?s, Spain?s Interest Rates: Is U.S. Next?

With the passage this week of the U.S. debt deal that lowered the budget deficit, Congressional Democrats and Republicans in Washington finally recognized that the budget deficit, in the long term, is a threat to the nation's economic and financial health.

But just when policy makers thought the financial crisis was winding down, new fears of contagion -- investors simultaneously dumping European nation bonds and forcing interest rates for these countries up -- has hit Europe.

European leaders are now racing to get ahead of the crisis, as investors push up interest rates in debt-burdened countries Spain and Italy, as they did in Greece and Ireland during the financial crisis' second wave. (The Lehman Bros. collapse was the first wave.)

Investors Push Up Spain's, Italy's Interest Rates

Institutional investors have already imposed a 'risk premium' on Greece: They've increased the interest rate that Greece has to pay to borrow money in credit markets for short-term debt, and have effectively locked out the country from borrowing long-term -- the interest rate is too high.

As a result, European Union officials were forced to de-couple Greece from the financial markets -- which means it will not have to seek loans in the free market, but will be able to borrow for an affordable interest rate from a special EU fund set up for that purpose.

European Union officials may have to do the same for Spain and Italy.

Spain's interest rate to borrow money for 10 years rose above 6 percent on Thursday, and was at 6.06 percent on Friday at mid-day.

Meanwhile, Italy's 10-year interest rate was at 6.16 percent on Friday.

In contrast, Germany can obtain 10-year loans for 2.30 percent.

Bond Vigilantes: Patient With U.S., So Far

Why is this important for the United States and for American taxpayer?

Presently, the U.S. Government can borrow money for 10 years at about 2.48 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 $1.16 trillion in fiscal 2012, the current fiscal year.

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

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 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 is not serious about deficit reduction, long-term, and that the U.S. will continue to run plus-$800 billion deficits through the end of the decade. The U.S. debt deal passed by Congress and sign by President Barack Obama this week is a good first toward deficit reduction -- but it's just that -- a good first step: it does not balance the budget.

To do that, Congress, via its appointment of a "special committee," must follow-through with the second half of the proposed cuts -- $1.5 trillion in all. The bipartisan committee will identify them by late November.

In addition, a tax increase, although not called for in the "special committee" list of options, invariably will have to be considered by Congress, most economists agree, if the U.S. seeks a balanced budget.

Inaction, and U.S. Interest Rates Could Surge

The penalty that will be exacted on the U.S. economy and the American people, if the committee fails, will be huge. If institutional investors ever conclude that Congress is not serious about deficit reduction, at that point 'the discount' or 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: 1) a massive cut in spending or 2) a massive increase in taxes. Or an onerous combination.

And, needless to add, 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 follow-through with the debt deal outline: the special committee must agree on a substantive, enduring deficit reduction package soon -- one that cuts the deficit, long-term.

Rest assured, the bond vigilantes are watching, and they appear to have been re-awakened by events in Europe.