Wall Street finds itself in a 1994 state of mind
By Rob Cox
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.
Wall Street is obsessing about 1994. But itâs not nostalgia for Ace of Base or âSeinfeldâ that has the financial industry atwitter -Â itâsÂ turmoil in the bond market.
A sudden jump in interest rates 19 years ago inflicted mega damage. Determining who is getting clobbered is todayâs parlor game in New York, London and Hong Kong.Â From the start of 1994 to October, yields on benchmark 10-year Treasury bondsÂ rose from 6 percent to over 8 percent, precipitated by an abrupt hike in interest rates by the Federal Reserve. In the past month, yields on the 10-year haveÂ increased from just under 2 percent to 2.6 percent.
The shift in 1994 caught many on Wall Street by surprise, including the mighty Goldman Sachs. Hundreds of millions of dollars in losses required the then-private groupâs partners to dip into their own bank accounts to recapitalize the firm.
Big bank bosses seem calm, though, saying itâs different this time – and there are crucial differences. Though the recent move, percentage-wise, is as big as in 1994, the absolute damage should not be as great. The change in the price of bonds is smaller – meaning lower mark-to-market losses. A doubling of yields from 2 percent to 4 percent would only lead to around a 15 percent loss of principal, compared to nearly twice as much when starting from a 5 percent yield.
On top of that, the big banksâ trading operations hold substantially more capital and liquid assets and, at least in the United States, cannot make big bets with their own money like they did two decades ago. These are the result of regulatory changes after the 2008 crisis – take your pick from Basel III, Dodd-Frank, Vickers, Volcker or Liikanen.
There could yet be carnage. Banks still carry some inventory. Major firms are pondering the effect of the 10-year yield hitting 5 percent. If all try to exit similar trades at the same time, the market could seize up and leave sellers stuck. Moreover, the Salomon Brothers prop trader of the 1990s is todayâs hedge fund superstar. But thatâs the whole point. The recent reforms were designed to chase risk-taking out of state-insured banks whose failure could precipitate a systemic collapse to institutions where private investors bear the losses.
In that context, a 1994-style bond market panicÂ would be an ideal test of the efficacy of the assumptions guiding regulatory reform.Â Come to think of it, maybe thatâs what the Fed is up to.