March 19, 2013 6:32 pm
Markets: The ghosts of ’94
By Michael Mackenzie, Robin Wigglesworth and Stephen Foley
Nineteen-ninety four. Nelson Mandela was inaugurated South Africa’s first black president. Ace of Base dominated the pop charts on both sides of the Atlantic. And Pulp Fiction introduced “Royale with cheese” to the vernacular. On Wall Street, 1994 was the year many money managers lost their shirts.
A sharp, unexpected rise in interest rates wrecked the value of bond portfolios and turned profitable trades into money losers. Hedge funds blew up, banks plunged into the red and the resulting shockwaves even hurt the equity market, which reversed a strong start to end down on the year.
It was, in other words, a year for investors to forget. But it is also a year that is important to remember. Today, with interest rates at rock-bottom thanks to the US Federal Reserve and other central banks, some bond market veterans are hearing echoes of 1994. What will happen, they ask, when the Fed decides it has done enough to stimulate the economy? Could there be another shock? Richard Tang, now head of North America sales at RBS Securities, recalls the “gigantic roar” that went up across the trading floor at Salomon Brothers on February 4, 1994, when the Fed unexpectedly raised rates.
“I remember 1994 very well, clearly like it was yesterday. It was my first bear market in the business,” he says.
The Fed kept tightening through the year, as the US economy picked up steam and the central bank decided to put down a marker against inflation. Traders who had loaded up on debt, notably in mortgage securities, were squeezed, and the leverage in the nascent securitisation market meant the pain was magnified.
US bond yields and Federal Reserve target rate
“It was Armageddon,” says Paul Griffiths, head of fixed income at Aberdeen Asset Management. “Everyone got crushed heading towards the exit at the same time.”
The bond rout claimed some powerful names. There were big trading losses at Goldman Sachs, leading Stephen Friedman to step down as its senior partner. Askin Capital Management was the largest hedge fund casualty, while Steinhardt Partners, the successful hedge fund run by Michael Steinhardt, was also hit hard.
Orange County, California, declared bankruptcy after losing money on a derivatives bet. Bankers Trust, the pre-eminent derivatives bank at the time, became trapped in a nasty war with its customers, including Gibson Greetings and Procter & Gamble, over inappropriate derivative investments foisted on them by aggressive traders. A trading scandal at Kidder Peabody was exposed during the rout, resulting in the storied firm being sold to Paine Webber.
Many investors had been lulled into a false sense of security that rates would remain quiescent. This was in some ways understandable: the Fed’s February rise was its first in six years. Until then, the central bank’s prescription for the sluggish economy – whose poor performance had cost President George H.W. Bush the White House – had been a long period of low interest rates, designed to nurture a recovery for the banking system and the housing market.
Not everyone felt so secure, however. Henry Kaufman, the former chief economist at Salomon Brothers, whose pronouncements moved bond markets, had warned that a change in Fed policy could quickly cascade through the financial system.
“There was at the beginning of the nineties a very slow economic recovery,” he recalls. “The economy was labouring to get going. The banks were recovering from a financial crisis. The financial market had already become significantly securitised, the junk bond market had become bigger, the derivatives markets were burgeoning. There were in the early nineties a few analogies to the current period – a few.”
In his State of the Union address that January, President Bill Clinton laid out a compelling argument for why the US economy was finally beginning to wake up. “Auto sales are way up. Home sales are at a record high. Millions of Americans have refinanced their homes. And our economy has produced 1.6m private sector jobs in 1993, more than were created in the previous four years combined.”
Bond investors weren’t quite so convinced and they discounted the prospect that Alan Greenspan’s Fed would begin to raise rates in the face of an improving economy.
The question today is whether low interest rates, signs of stability in the housing market and improving jobs data are a prelude to a stronger rebound for the economy this year.
Today’s traders and investors are keenly sensitive to the Fed’s latest thinking on monetary policy, thanks in part to more open communication from Mr Greenspan’s successor, Ben Bernanke. Now it telegraphs the evolution of its thinking through policy statements, minutes of meetings and countless speeches. Nineteen years ago, it didn’t always even announce rate changes. Markets react instantly on any clue as to when the central bank might finally signal its intention to wind down quantitative easing.
“The market, justifiably so, is constantly nervous about a rate sell-off,” says Mr Tang. “These artificially manipulated rates by central banks make people nervous and they are uncomfortably long equities and credit. We have never seen a major central bank exit QE and you can’t say fears among bond investors are not justified.”
The state of nervousness could be read as a positive sign of a determination not to be taken by surprise again.
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There has been one big rate tightening cycle in the intervening years, after the end of the early 2000s recession. From June 2004, the Fed implemented 17 well-telegraphed rate increases, pushing the funds rate up in quarter-point increments to 5.25 per cent, without crippling the bond market.
“We are talking about two very different eras,” says Mr Tang. “Jurassic versus Prehistoric is how I would define how the bond market has developed since 1994. That was an era of imperfect information. We just had green screen terminals with bond prices. You had to go and seek out your economist’s opinion to find out what was happening. I had no email, no Bloomberg terminal. There was nothing like the proliferation of information that we have today.”
Compounding the adverse reaction to Fed rate increases in 1994 were some important aspects of the bond market’s structure. For the first time, bond investors had to understand how mortgage securities would seriously underperform and lose money for investors as underlying interest rates rose. This time the Fed may have the tools to curtail a rise in bond yields.
So it is different this time. History cannot repeat itself. But will it rhyme? Much the same way as the Black Monday crash of 1987 now looks a blip on a chart of the equity market of the past 30 years, the interest rate rises of 1994 barely register on a long-term graph. Since Paul Volcker, Fed chairman at the start of Ronald Reagan’s presidency, licked inflation with viciously high rates, the trend has been almost relentlessly downward, until the 2008 financial crisis and the era of zero per cent short-term rates.
The scale of the current bond bull market means that its end could be far more serious than anything seen in 1994.
Apart from the distorting effects of Fed bond buying on the Treasury market, there has also been a change in the size of interest rate-sensitive markets since 1994. The value of outstanding bonds – $37.7tn at the end of September 2012 – is three-and-a-half times what it was 19 years ago.
There are vastly more hedge funds and ordinary investors who own bonds now, and money going into bond funds has accelerated sharply since the crisis, according to Lipper, the data provider. Inflows reached $309bn in 2012, taking the total to more than $1tn since 2009.
The emergence of exchange traded funds means that it is easier and cheaper than ever for investors to bet on movements in the bond market. Inflows into bond ETFs rose to $51.4bn in 2012, up from $12.7bn in 2007. And the market for interest rate swaps has also ballooned, with the face value of these instruments now over $500tn. These can help investors offset the damage from sharply rising interest rates. They can also help aggressive investors bet profitably on such a development, thereby exacerbating any future sell-off.
William Strazzullo, chief market strategist at BellCurve Markets, who 19 years ago was trading short-term interest rates for Paine Webber, says today’s investors will look to sell bonds to ride yields higher, potentially fuelling an overshoot.
“If it gets going, it will take on a life of its own,” he says. “In 1994, most people were in their cubby hole focusing on one specific area, whereas now there are a lot more people willing to jump on a trend. People are salivating at the idea of the bond bubble ending and the move to higher rates will be explosive. It will be worse than 1994.”
One person with plenty of experience of rising rates is Dan Fuss, the vice-chairman of Loomis Sayles, who has been investing in bond markets for more than 50 years. He says that “no one knows the future” but warns that investors are “probably at the foothills of gradually rising rates, ahead of a mountain of high rates”.
The Fed has promised to hold short-term rates as close to zero as possible until US unemployment has fallen from today’s rate of 7.9 per cent to 6.5 per cent – something that could take another two years.
What the central bank wants to see is a period where long-term rates go up first, as the economy improves, before it raises the cost of short-term borrowing. That way banks and other financial firms can still make money by borrowing cheaply and lending it out at higher rates. Most of all, it wants the shift to higher rates to come slowly.
Mr Bernanke has not been quiet about the prospect of higher long-term bond yields and the risk that a sharp jump will inflict capital losses on bond holders and financial institutions. Citing the 1994 experience in a speech on long-term interest rates, Mr Bernanke says the central bank provides far more clarity about its policy intentions and could act to stem a sudden rise in rates.
As in 1994, it could be the strength of the economic recovery that is the wild card. Strong employment data in March, 1994, accelerated the stampede out of bonds. Today, the risk is a big uptick in job creation that hits the Fed’s unemployment target before the market is ready.
Rick Klingman was at the centre of the storm in 1994, as he traded for Yamaichi International in New York. “It’s hard to convey just how hard people got crushed by the rate hikes and higher yields across the bond market,” says Mr Klingman, now with BNP Paribas. “There was total dislocation. No one in ’94 was prepared for the rate hikes and a lot of people got exposed by the severity of the Fed’s tightening that year.”
That was 19 years ago and there are not that many traders left who have felt the lash of sharply tighter monetary policy. That is a warning sign for Mr Klingman. “The bond market today is full of people trading who have not encountered an aggressive rate tightening cycle.”
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Copyright The Financial Times Limited 2013.
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