Tuesday, October 7, 2014

The Bond Market Massacre

While the Federal Reserve is telegraphing that interest rates are likely to remain at their current near-zero interest rate levels for the foreseeable future, the Fed's dot plot suggests that the FOMC expects that interest rates will rise from their current level of 0.25 percent to 1.25 percent in 2015, to 2.75 percent in 2016 and to 3.75 percent in 2017 as shown here:

Since bond prices fall as interest rates rise, the Fed's actions could have a substantial negative impact on the value of bonds.  Such a negative impact on the value of bonds is not unprecedented.  In this posting, we'll look at one historical precedent for falling bond prices and the impact on bondholders and the financial industry as a whole.

Let's start by looking at the Federal Funds rate from 1954 to the present:

Notice that the period since 2009 is anomalous with the Fed Funds rate just above zero percent for a historically unprecedented period of time.

Let's zoom in on one time period in the mid-1990s:

Between January 1994 and March 1995, the Federal Reserve increased the Fed Funds rate from 3 percent to 6 percent.  During that 15 month period, bond investors were slaughtered in what has become known as the Great Bond Market Massacre of 1994.  It is also important to note that the interest rate increase of 0.25 percent was the first interest rate increase in five years.

While shorter-term interest rates were obviously impacted by the Fed's interest rate manipulations, long bonds were also impacted as shown on this graph:

Ten year Treasury yields rose from 5.2 percent in mid-October 1993 to what now seems like a stratospheric 8.0 percent in early November 1994, an increase of 2.8 percentage points.  Since, as I noted above, bond prices act inversely to yield, bond holders saw the value of their so-called safe haven bond investments plummet.  

The same thing happened to corporate bond holders as shown on this graph:

Baa rated corporate bond yields rose from 7.3 percent in October 1993 to an unimaginable 9.3 percent in November 1994.

With long-term interest rates on the rise in every major country during 1994, it was estimated that total drop in the value of bonds on the world's bond markets was in the order of $1.5 trillion.  With far higher volume of sovereign bonds now (because of far higher government debt levels), it is quite likely that the total drop in the value of bonds in a repeat of 1994 could be far higher than $1.5 trillion.  For example, according to the Economist, in 2003, total global public debt was around $23 trillion compared to $54 trillion in 2014, a doubling of the total sovereign debt.

In the case of the 1994 bond market meltdown, the turbulence was worldwide.  In Europe, bond market volatility increased as foreign investors liquidated their holdings of government bonds, a scenario that could easily be repeated given that there are still substantial sovereign debt problems in Europe that have not been resolved since the PIIGS debt crisis of 2011 - 2012.  Price changes/volatility in one bond market spilled over into other bond markets as shown on this diagram:

With the global economy even more interconnected today than it was in 1994, the odds of a bond market spillover are even greater now.

In 1994, the biggest losers were the hedge funds that had bet on a continuing decline in European interest rates.  One company, Steinhardt Partners, lost approximately one-third of the total amount that it had under management.  Askin Capital imploded under the weight of its losses.  Askin had $600 million worth of assets under management which were invested in Collateralized Mortgage Obligations.  When rising interest rates drove down the value of the CMOs, Askin was forced to file for bankruptcy and left its investors holding little more than thin air.   Other losers included the banking and insurance industries with calculations showing that property and casualty insurers saw portfolio values decline by around $20 billion.

Could bond market history repeat itself?  With the Fed Funds rate at essentially zero, the only way that interest rates can go is up.  While the Federal Reserve is doing its best to telegraph its future interest rate plans, the market may have other plans as shown here:

Over a four month period in 2013, ten year Treasury rates rose from 1.7 percent in May to 3.0 percent in September, an increase of 76.5 percent despite the fact that the Fed had not increased the Fed Funds rate and was still operating under its QE mantra of pushing long rates down.  This shows us how tenuous the Federal Reserve's control is over the bond market.

Professor Martin Feldstein, a Professor of Economics at Harvard University and President Ronald Reagan's chief economic advisor who believes that the bond market is in a bubble of the Fed's making because of their asset purchase program, was asked what the Federal Reserve should do regarding interest rates.  His response?

"Pray; it's one of the remaining untried tools." 

We can only hope that Dr. Feldstein is wrong but history does have a strong tendency of repetition.


  1. I agree that the value of the old bonds will go down.
    But, the interest on the new bonds will go up, an advantage for individual investors, pension funds, and insurance companies.
    Are you saying that sovereign bonds should fluctuate more than private bonds?
    Don Levit

  2. In response to Don:

    There must always be a potential buyer and a seller in any transaction. Thus, holders of bonds wishing to sell them in the bond market must attach a premium to off-set the difference in interest rates. So as interest rates increase over a period of time, holders of bonds wishing to unload them will have to take a hair-cut to make their fixed income instruments viable for sale on the bond market.

    So even as current investors are able to take advantage of higher returns (higher interest rate coupons) on stated instruments, there must me a market to offer them. The problem with this is when interest rate volitility takes hold, there is a lack of liquidity (aka credit crunch) in the market as expectations on inflation and interest rate movements become very diffciult for the market to price in risk. As such, even with higher potential returns on fixed income securities, markets are iliquid due to perceived market risk.

  3. I'm not sure that the Fed actually WILL raise rates that much.

    First, the real economy is still in bad shape. That is self-evident to sober people on Main Street, even if Wall Street is partying until it has completely drunk all of the excess liquidity.

    Second, with a national debt held by the public of $12.8 trillion, every 1% rise in the average rate is another $128 billion per year of interest payments. If rates go from 0.25% to 3.75%, and Treasury rates increase in step, that's around $450 billion in additional interest payments.


    Add in the expected increase in the debt by 2017 and that's at least half a trillion dollars, per year, every year, until the next recession forces rates to ease again.

    Will Congress allow the Fed to, in essence, raise taxes by half a trillion dollars per year? I suspect not.

  4. Such a rise it rates should not be unexpected or over the top. For months the major world currencies have traded in a narrow range as if held in limbo by some great force. This has allowed people to think we were on sound footing as central banks across the world continued to print and pump out money chasing the "ever elusive growth" that always appears to be just around the corner. Recently some currencies have made multi-year highs or lows depending on the match-up .

    Because of weak demand for goods and most of this money flowing into intangible investments inflation has not been a major problem, but the seeds for its future growth have been planted everywhere. John Maynard Keynes said By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

    While there are not many Bond Vigilantes there are a slew of Currency Vigilantes and they are ready to make their presence known. Weakness in the value of the Yen, Pound, and Euro must not go unnoticed. More on why this may be a signal that currency trading is about to get very wild in the article below. Please note, this may also be sending a signal that the whole system is unstable and the stock market is about to drop like a stone.