Parallels to 1994 terrify bond players who remember the rout that accompanied the Federal Reserve's tightening campaign of that year. And while enough differences exist between then and now to suggest the pain of interest rate hikes won't be as severe, investors would be unwise to write off the similarities completely. Over the past five weeks, bonds have sold off amid growing expectations for a rate hike this summer. Although the market appears to have stabilized in recent days, analysts and investors remain concerned that history will repeat itself. "Will 2004 replay the bond market bloodbath of 1994?" asked Richard Berner, chief economist at Morgan Stanley. "At this juncture, bond market carnage seems unlikely. But there are also similarities, many of which support our bearish stance on bonds." Back in 1994, the Fed embarked on a series of interest rate hikes after keeping monetary policy on hold for an extended period. The result was a veritable crash in bonds. The yield on the 10-year Treasury rose to more than 8% in November 1994 from just 5.7% before the first hike came in February of that year. Conventional wisdom holds that the Fed didn't communicate its intentions well enough to the financial markets and that the six rate hikes -- which pushed the fed funds rate up to 5.5% from just 3% -- came as a shock. "Only a few people had an inkling of what was happening," said Jim Bianco, president of Bianco Research. "Now, a lot more people have an understanding of what's happening." Indeed, fed funds futures are pricing in at least 50 basis points of tightening by the Sept. 21 meeting. Pundits also note that the outlook for inflation is different this time around and that the Fed can afford to be more patient in raising rates than it was back then.
"The major difference now is that inflation is on the order of 1.5%
compared with 3% back then," said George Lucas, head of Treasury Strategy at Banc of America Securities. "They were more pre-emptive before, where now the Fed is willing to tolerate a slight uptick in inflation." Last week, Federal Reserve Chairman Alan Greenspan hinted that sharp increases in rates weren't likely because "extraordinary productivity acceleration" is keeping inflation under control. Meanwhile, Fed Governor Ben Bernanke said that long-term interest rates might already reflect future changes to the fed funds rate. Morgan Stanley's Berner notes that investors were surprised by a strong global recovery in 1994, but that "consensus forecasts today already anticipate hearty economic growth." Still, analysts worry that speculation in the market is as rife as it was 10 years ago and that any increase in short-term rates could spark a major selloff. Bianco said he is concerned that hedge funds, traders and financial institutions are still betting that the yield curve will remain steep if the Fed raises rates this year. A steep yield curve implies that long-term rates are much higher than short-term rates. "Most carry traders are not betting against a general rise in rates, they're betting that the yield curve will stay fairly steep," he said. "So if we get Fed policy that takes short-term rates up fast and flattens the yield curve, that will hurt." Carry traders borrow funds at low short-term rates and buy longer-dated bonds, which have higher yields. According to The Wall Street Journal, some traders have been using over $25 of borrowed money for every $1 of their own in making this trade. Even if long-term Treasury yields stay where they are after a Fed tightening or edge down -- which Bianco believes is possible for a variety of reasons -- many players will still be crushed because they aren't betting on a flattening yield curve, he said.
Other analysts worry that the mortgage convexity trade will exacerbate any downdraft in the bond market. That works like this: When interest rates rise, prepayments from homeowners tend to slow down, which causes the average life of mortgage portfolios to increase. As this happens, money managers begin to unwind some of their hedges by selling Treasuries. The opposite happens when interest rates are declining. As prepayments increase, the average life of mortgage portfolios tends to decrease and investors purchase long-dated Treasuries to increase the duration. A decade ago, the mortgage market was far smaller than it is today and analysts worry that this specific trade could have a larger impact than anyone is currently expecting. "The threat to this whole thing is mortgage convexity selling," Lucas said. "The mortgage market is bigger now, especially relative to the Treasury market." Sadakichi Robbins, fixed income analyst at Julius Baer, is less concerned about the amount of leverage in the market because he believes that financial institutions in particular are much better positioned than they were 10 years ago. In a speech before the Senate Banking Committee last week, Greenspan said banks are well prepared for higher interest rates. "At this point, the probability of a 1994-event isn't extremely likely," Robbins said, noting that he expects the 10-year note to end the year at 4.75% to 5% even if the Fed hikes rates three times. Some analysts note that foreign central banks, which have been big buyers of Treasuries recently, are likely to mitigate any selling that does take place this year. But others worry that investments from abroad could slow down, hurting bonds even more. One big difference between 1994 and today is that the government isn't taking convincing steps to reduce the budget deficit and, at some point, analysts say foreigners could start to take note of that.
Robbins also conceded that the market does have a tendency to overshoot at times. If investors begin to feel that the Fed is behind the curve and inflation expectations jump sharply, bonds could well see severe declines. But just like 10 years ago, Treasury yields probably wouldn't stay high for very long. Although yields peaked at over 8% in 1994, they plunged the following year and were sitting at 5.6% by December 1995. The decline in yields also accompanied a huge stock market rally, with the S&P 500 jumping 34% that year after a 1.5% decline in 1994.