Fears of 1994 bond market flashback
The 1994 bond market massacre is remembered with horror by those who lived through it. Yields on 30-year Treasuries jumped some 200 basis points in the first nine months of the year, hammering investors and financial firms, not to mention thrusting Mexico into crisis and bankrupting Orange County.
The accepted story is that an over-eager Federal Reserve set off the carnage by raising interest rates too soon – the sort of premature move that current Fed Chairman Ben Bernanke has suggested, again and again, that he is not going to make.
But what if the conventional wisdom about 1994 is wrong? Steven Englander, Citigroup’s head of G10 currency strategy, says that when it comes to the Fed’s balancing act of a mandate – price stability and full employment – the Greenspan-led incarnation, in this instance at least, deserves top marks.
The Fed’s tightening cycle, which began with a modest 25-basis-point hike in February, pushed short-term interest rates up by 2.25 percent by the end of the year. Yes, Treasuries and the dollar took a beating. But by 1995, the Fed could point to a lower jobless rate (5.5 percent vs 6.5 percent in early 1994), falling inflation and slower compensation growth. And, of course, an economy and stock market that were about to take off.
In other words, 1994 was a great success, at least in terms of the dual mandate. To the FOMC, inflicting pain on over-leveraged bond investors may well have seemed an acceptable price to pay.
This, Englander says, should cause some concern for investors who think the Fed’s eventual exit from its current stimulus program, which has helped usher in a record high in the Dow industrials and a record low in 10-year Treasury yields, will be as friendly as Bernanke et al have implied.
The Fed’s dual mandate is inflation and labor markets. They have supported asset market robustness because they view strong asset markets as consistent with the dual mandate, but it is unclear how long that implied commitment will last once they get into the economic normalization zone.
Of course, the Fed will almost certainly avoid doing or saying anything at the end of its policy meeting this week that suggests it will soon stop or even slow its monthly purchases of $85 billion Treasury and mortgage-backed bonds.
U.S. economic data has improved, but not enough to warrant tightening yet. And Europe may have provided yet another assist to easy U.S. monetary policy with its Cyprus bailout plan.
But as Englander put it:
Right now, the Fed supports strong asset markets because they support their macroeconomic goals. So the question is, will they be as comforting when the unemployment rate approaches 6.5 percent? Would they ditch the immaculate exit strategy?
It bears thinking about, since the damage to investors who have been feasting for years on cheap money could be far worse than it was in 1994. With yields already near record lows, a sharp rise in interest rates would impose much steeper losses today than they did in 1994, when yields were higher.
Overall the 1994 experience suggests that the possibility of a disconnect between economic and asset market conditions cannot be ignored.
Of course, continuing with current policies indefinitely could do just as much damage.
Bank of America Merrill Lynch strategist Michael Hartnett warned recently of a “repeat of the 1994 moment” if the unemployment rate keeps slipping and job growth breaks into the 300,000 per month range, inducing the Fed to tighten policy.
If U.S. growth does shift into higher gear later this year or next and inflation expectations start moving higher, rolling the dice with another round of QE probably won’t be possible, Ashmore Investment Management strategists wrote in a recent note to clients.
More QE at a time when the market is worrying about inflation and wants to see higher yields means only one thing for the U.S. dollar — it goes down. And the resultant move lower in the U.S. dollar has implications for everyone on account of its reserve currency status.