Sell-side denial of a repeat of the 1994 market sell-off

By:
Euromoney Skew, Sid VermaDuncan Kerr
Published on:

For all the chatter among sell-side analysts on the possibility of the bond markets crashing in the way that they did in 1994 on the Federal Reserve's rate tightening, their buy-side clients appear less concerned.

In 1994, the combination of stronger than expected US payroll numbers, aggressive rate tightening by the Fed, and a 200 basis point back-up in bond yields put a break on the nascent equity bull market and caused a savage reversal of fortune in leveraged areas of the fixed-income markets.  

Such a reversal caused havoc, bringing about the bankruptcy of California's Orange County, the tequila crisis that engulfed Mexico and an exceptionally close call for Goldman Sachs. 

Scarily, the same could be expected to happen again, according to some sell-side analysts, should the global economy and corporate animal spirits revive sufficiently to cause a surprise uplift to US payroll numbers in the coming months, says numbers in excess of 300,000, potentially forcing the hand of the Fed to tighten monetary policy.   

However, in a note from Bank of America Merrill Lynch, analysts struck a sanguine tone: 

“Interest rates are not seen as a big threat by the majority of clients. Very few expect a. the labor market to induce a big rise in yields, b. the Fed to allow yields to rise much above 2.5% and c. the economy or the debt situation in the US to permit a rise in yields to be large and permanent. Demographics and the regulatory background were also stated as reasons for low and stable rates. Inflation is possible, but unlikely. At a client dinner, no-one thought the 10-year Treasury yield would exceed 3% by year-end.”  

Nevertheless, recent Fed minutes add fuel to the argument that QE might be halted by year-end. Here's the view from Paul Ashworth, chief US economist at Capital Economics: 

“The key takeaway from the minutes of the last FOMC meeting in mid-December is that Fed officials might end quantitative easing sooner than the markets were expecting, triggering a rise in Treasury yields and the dollar. Officials were concerned that "the benefits of ongoing purchases were uncertain and... the potential costs could rise as the size of the balance sheet increased." The Fed is now buying $85bn of Treasury securities and agency MBS each month, which adds up to roughly $1trn per year. As a result, the Fed's already bloated balance sheet will increase by about 40% in 2013.

Officials are worried that such an expansion could prompt a surge in inflation expectations and would make it more difficult, when the time eventually came, to implement any exit strategy. According to the minutes "a few members" thought that the purchases should continue until the end of 2013, while "several others" thought they should be stopped "well before" the end of this year.

Given that the Fed isn't expected to start raising interest rates from near-zero until mid-2015 or even later, most commentators had expected the asset purchases to continue well into 2014. That said, it was always possible that the Fed would reduce its monthly purchases before then. Ultimately, it is the prevailing economic conditions that will determine when the Fed halts or slows the pace of its asset purchases. We suspect that another year of lacklustre economic growth in 2013, coupled with only a modest improvement in the unemployment rate, will persuade the Fed to sustain QE into 2014."