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Lest we forget the lessons of the ‘94 market

Keith Mullin  

Keith Mullin  

“Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. The action is expected to be associated with a small increase in short-term money market interest rates.

The decision was taken to move toward a less accommodative stance in monetary policy in order to sustain and enhance the economic expansion.

Chairman Greenspan decided to announce this action immediately so as to avoid any misunderstanding of the Committee’s purposes, given the fact that this is the first firming of reserve market conditions by the Committee since early 1989.”

Remember that? The by-now infamous Federal Reserve announcement of February 4, 1994 – which was accompanied by a 25bp rate hike – is firmly emblazoned on the minds of bond market veterans and continues even now to strike fear and loathing in their hearts. It’s become one of those “where were you when Kennedy was shot” moments for the fixed-income community.

Why? Well, not just because it caught the market unawares and totally off guard, but because that small innocent-looking hike was followed by a brutal succession of half a dozen additional rate increases that caused the Fed funds rate to double to 6% from 3% within a year. The impact was dramatic: The mark- to-market value of investors’ bond holdings went into free fall and the carry trade imploded.

The 1990s had witnessed a dramatic increase in the use of leverage, invariably using newfangled derivatives. As the market had industrialized, so the ability to take speculative positions had increased exponentially. And everyone did just that – speculate in government and agency paper, in corporate bonds, in mortgages and asset-backed securities as well as structured products. And the rate environment had unleashed an easy- money carry trade where cheap Fed funds financed Treasury positions.

Across the spectrum, the rate rise had an immediate impact on bond yields. As bond prices shifted lower to adjust to the new environment, hundreds of billions of dollars – some estimate as much as US$1.5 trillion – were immediately wiped off the value of outstanding bonds.

Those that could do so dumped paper or unwound positions as fast as they could in a vicious one-way trade, exacerbating the ferocious effects and sending many bond funds managed by insurance companies, pension funds and hedge funds as well as bank proprietary positions into the tank – or even over the edge into the abyss.

Lessons learned

Alan Greenspan’s intent to calm inflationary tendencies in the U.S. economy ended up causing a market collapse the likes of which wasn’t seen again until 2008-09 in the aftermath of the Lehman Brothers collapse.

An additional element to the chaos of 1994 was the powerful downswing in emerging markets (EM). In March of that year Luis Donaldo Colosio, Mexico’s PRI presidential candidate, had been assassinated at a political rally in Tijuana. In December, the newly elected government of Ernesto Zedillo devalued the Mexican peso, causing a massive disruption in emerging markets – aka the Tequila Crisis – that saw investors yank capital out of Mexican assets, triggering a worldwide domino effect that roiled other emerging markets.

Net-net, 1994 was not a good year.

In many ways, though, it was the year U.S. and international monetary policy makers finally got the joke: that financial markets had evolved into a globalized, interconnected power with a heretofore unseen destructive force.

More to the point, they learned that the ability of financial markets to use that destructive force could not be ignored and that however much they might dislike the games of “cat and mouse” between policy actions and market agents, it had become a fact of life. That’s one of the key legacies of the events of 1994.

Twenty years later …

To that point, fast-forward 20 years plus. How has the pain of that period impacted the way in which monetary policy is conducted today? Well, think about it: What has been the single, biggest constant over the past year or so in the psyche of bond market professionals since the Federal Reserve curtailed its policy of quantitative easing?

It’s the global impact of that pesky rate rise. It’s been the dominant, controlling factor behind fund flows, behind speculative forays, behind new-issue volumes, spreads and premia, behind global bond market performance, behind the fortunes of financial markets way beyond the shores of the U.S.

Now that the September rate hike that most bond strategists were convinced was going to materialize has failed to emerge, the expectations have shifted to the first quarter of 2016. But that doesn’t mean the issue has receded as a key driver of bond market sentiment and tone.

Policy makers may stick to their domestic inflation- centered language but at the press conference following the September Federal Open Market Committee (FOMC) meeting, Chair Janet Yellen gave the clearest signal yet that global factors are actively at play inside what everyone had considered to be domestic policy circles.

Ditto the latent power of the market to show its pleasure or displeasure and create ripples of unintended consequences. Central banks may not like to admit that the market forces their hand, but it’s become one of those unwritten laws that define the state of the universe.

In this, what strikes me is that financial technology may have evolved since the mid-1990s; the use of sophisti- cated computer modeling has become ubiquitous; the global marketplace has risen dramatically in size and stature; but the panic of 1994 in my view was a defining moment in the conduct of monetary policy.

Or better put, avoiding the mistakes of 1994-95 has become a defining moment. How many times have we heard over the last couple of years that 2015-16 won’t be 1994-95? That period and the actions taken have become a poster child for how not to proceed and that policy makers at their peril ignore what’s at stake not only regarding the domestic economy and asset prices but the wider impacts in a fully globalised economy and financial sector.

And just as Mexico and emerging markets suffered huge fallout from the impacts of domestic U.S. monetary policy and other related factors back in 1994, what’s been among the top three concerns and anxieties impacting the general monetary environment in 2015 and who’s going to suffer most from a U.S. rate rise? You’ve guessed it: emerging markets.

Modern financial sophistication, it seems, accounts for little to nothing in a “plus ça change …” world. We may have gained BRICS (Brazil, Russia, India, China, South Africa) or MINT (Mexico, Indonesia, Nigeria and Turkey) groupings as outward signs of the newfound force as the world economic structure morphs into a new paradigm. We may end up with the renminbi in the IMF’s Special Drawing Rights basket. But the central importance of the U.S. economy, the U.S. dollar, and dollar and dollar-linked assets suggests the power of U.S. monetary authorities to influence world financial outcomes continues intact.

The dollar bond market reigns supreme for inter- national governments, banks and corporations. It’s the extent of U.S. dollar borrowing – which has risen dramatically in recent years – that now holds a key to the complex jigsaw puzzle. A rate rise won’t just have an effect on bond portfolios, it will have an immediate impact on the currency markets and will increase the local currency-equivalent debt service burdens of emerging market borrowers.

Such a rate rise will lead to a reversal of fund flows as the yield-seeking behavior of global investors “normalizes” and leads to capital outflows from emerging markets. In countries that need foreign capital inflows to cover current account deficits,  the impacts could be particularly pronounced.

It’s become a bit of a cliché to laud the developments that have taken place in financial markets over recent years as the Young Turks of global finance flex their muscles and project to the fore what they see as their contributions to the industry’s emerging new structure.

But in a world that has been immersed in the global debt super-cycle for so long that many have never experienced a tight money environment, a fascinating and somewhat amusing side story to today’s market is that 40-50-somethings are once again in demand.

Now how often do you hear that in today’s world?

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