Two weeks ago, when the January Jobs Report showed wage gains up 2.9% from a year ago, triggering inflation fears, the bond market freaked out and stocks started tanking.

That’s behind us now. Or is it?

Sure, stocks have recovered and the 10-Year Treasury yield is lower, but inflation fears are still out there – and that means bond vigilantes are lurking in the shadows and could hijack markets again.

Here’s the truth about inflation, the origin of these bond vigilantes, and how the market will react to all of this…

The Great Bond Massacre

Bond vigilantes are Treasury bond market investors and traders who protest monetary or fiscal policies they consider inflationary by selling and shorting Treasury bonds, which increases their yields.

They’re vigilantes because they theoretically act as a restraint on the government’s ability to overspend and over-borrow by raising borrowing costs as they push interest rates higher.

The term first originated in 1993 during the Clinton administration, when bond sellers pushed US 10-year yields from 5.2% to just above 8.0% over market concerns about federal spending.

That sell-off became known as the “Great Bond Massacre.”

Starting last September, with U.S. GDP growth already expected to pick up, new bond vigilantes began selling Treasuries anticipating massive tax cuts and the president’s push for infrastructure spending would stimulate the economy above trend and spark inflation.

From just above 2% in September last year, 10-year yields spiked to 2.85%. When higher than expected wage gains numbers came out two weeks ago, the 10-Year yield shot up to 2.95%, a four-year high, triggering an across the board stock market selloff.

Now, with stocks having recovered three-quarters of their losses and the 10-Year Treasury yield back down to 2.84%, stock and bond investors seem to think inflation fears are overblown.

It’s Called the “Amazon Effect”

Treasury Secretary Steven Mnuchin weighed in last week on what he considers overblown fears saying, “There are a lot of ways to have the economy grow… You can have wage inflation and not necessarily have inflation concerns in general.”

For the most part, he’s right.

While the unexpected uptick in wage gains is an inflationary additive, gains aren’t necessarily sustainable, and other inflation measures remain at bay, for the time being.

The rate of inflation, using the Fed’s preferred PCE index (Personal Consumption Expenditures Price Index), rose to 1.7% last year from 1.2% in 2015. It was just 0.3% in 2014.

However, the CPI (consumer price index), which analysts say better reflects what Americans pay for goods and services, was running at a 2.1% rate at the end of 2017.

That’s not a big deal. The Fed’s been trying to get inflation up to a 2% level for years now. If we’re there based on the CPI, that shouldn’t surprise anyone. In fact, it should be healthy.

The fact is it’s been a decade since inflation reached 3%, a level that would be concerning. We’re nowhere near that and probably won’t get there for a long time to come.

Lots of factors are dampening inflation and wage inflation in particular, including a huge move toward automation, global competition, and online shopping – with its price comparison advantage or “Amazon effect.”

Customers can see prices from all over the world, making it harder for companies to raise prices and make them stick.

With no real inflation immediately in front of us, or out in the future, it doesn’t make sense that bond vigilantes would be selling bonds causing yields to spike.

But they did and may well start doing so again.

We’re Not Out of the Woods Yet – Be Vigilant

If GDP growth starts to rise above trend, which has been 1.5%-1.75%, that would be one arrow in their quiver.

The Atlanta Fed’s GDPNow report sees GDP growth at 4%. That would be a shock to the system and bring out the vigilantes.

As the massive tax cuts enacted last year put more money in consumers’ hands, more money in corporations’ hands, and generated more spending across the economy, inflation could rear its head at a much faster rate than anyone expects.

And, if the Trump administration is successful in generating lots of infrastructure spending while adding to already towering deficits, there’ll be even more money floating through the economy as building generates jobs, production, manufacturing, and spending. All inflation inputs.

They’re out there.

The bond vigilantes are only resting, having pushed the yield up on the 10-Year almost 50% in less than six months. If markets get back on track and the economy perks up as it’s expected to, bond selling will pick up along with the expanding economy and inflation fears.

We’re not out of the woods.

What’s important to watch is what happens when the 10-Year yield gets to 3%, which is coming.

If hard selling by vigilantes when the yield gets above 3% pushes the 10-Year yield up quickly,

If the hard selling by vigilantes pushes the 10-Year yield above 3% – meaning 3.10% to 3.25% – the losses on existing bond portfolios will be staggering and will spur cross-asset selling.

That means stocks will drop again if bond yields spike.

You’ve been warned. Now, be vigilant.