This Market Was Murdered in 1994 - and It's Happening Again - Vivek Kaul's Diary
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This Market Was Murdered in 1994 - and It's Happening Again

Dec 14, 2016


The election of Donald Trump was a shock to most people. And to many investors in recent weeks, market reaction has been even more surprising. It's been good for stock markets, with the MSCI World - a global markets index - up 4 percent since the election, and the S&P 500 up 5.6 percent. But it's been catastrophic for bond investors.

Before the U.S. elections, we noted that U.S. treasury yields seemed to decline as Trump's odds of winning the election rose. The theory was that the financial world was nervous about Trump becoming U.S. president.

So investors bought "safe" U.S. treasuries to protect themselves from any market turmoil if Trump won. And the more they bought, the higher Treasury prices went... and the lower yields fell. (Bond prices and yields have an inverse relationship.)

But U.S. Treasury yields, and other bond yields, have done nothing but move up since Trump won the election. This means bond prices have been falling... which means investors are selling, not buying, lots of bonds. Prices for the iShares Barclays 20+ Year Treasury Bond ETF (NYSE; ticker: TLT) have fallen 10 percent since the November 8election. That's a big move for a stock... and it's an earth-topples-off-its-axis move for the bond market.

And overall bond yields have soared. U.S. 10-year Treasury yields have soared 28 percent. The average yield on the Bloomberg Barclays Global Aggregate Total Return Index, which measures the global bond market, climbed from a record low of 1.07 percent on July 5 of this year to 1.61 percent on November 23. That's 50 percent higher in just a few months.

And the 10-year German bond yield has climbed to about 0.4 percent from a July low of almost negative 0.2 percent.

The last time bond yields rose this rapidly, and unexpectedly, was in 1994. And that quick rise in yields cost bond investors over US$1 trillion dollars.

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Setting the scene for the Bond Market Debacle

What happened in 1994 is known in some circles as the Bond Market Debacle. And it could give us some clues how the current bond market roller coaster ride could end.

In case you didn't know, world's largest securities market is the bond market - not the stock market.  About US$700 billion worth of bonds trade every day - compared to the US$200 billion worth of stocks that trade per day. But, as we've explained before, bonds aren't the life of the financial world's party ("Let me tell you about the great bond I just bought" is not a show-stopper of a line), so they often get overlooked.

But the bond market does assert itself occasionally. And in 1994, "bond market vigilantes" forced the market to do so with a vengeance.

In January 1994, the bond market looked similar to today: Bond yields were low and inflation was low.  Back then, the Federal Funds Target Rate, or the "Fed rate," or "base rate," sat at a then-low, but still healthy, 3 percent. For comparison, the rate right now is 0.50 percent (and there's a very good chance it could rise to 0.75 percent when the U.S. Federal Reserve meets today and tomorrow).

The Fed thought it could nudge up rates in early February 1994, to do a little financial housekeeping.

Alan Greenspan was the head of the U.S. Federal Reserve back then. And he had a lot of sway over the stock market. For instance, one day about 20 years ago, he made a speech that said investors were "irrationally exuberant." The next day, the Dow Jones Industrial Average dropped 300 points.

There was no official policy change. Word had got around about his speech, that was all. That was the kind of power Greenspan had over the markets.

But back in 1994, Greenspan didn't say much at all about the bond market. Greenspan just started raising rates from that very low (at the time) 3 percent. And the bond market didn't like it one bit.

The fallout from rising rates

Greenspan didn't just raise rates once or twice. He raised rates 7 times from February 1994 to February 1995, as shown below.

It meant the Fed rate doubled from 3 percent to 6 percent.

Remember, when yields are rising, it means bond prices are falling. And in 1994, they fell. Hard.

Bond investors and fund managers were caught off guard. They didn't have time to adjust their bond portfolios, as the Fed didn't indicate, or signal, that it would keep raising rates.

Fortune magazine called it "The Great Bond Market Massacre," and with good reason. The total losses suffered by bond investors and managers totalled over US$1 trillion dollars.

That's what happens when interest rates double unexpectedly. As you can see above, Greenspan had to cut rates later that year, since rates climbed too far, too fast.

The bond market vigilantes

So-called bond market vigilantes were one of the reasons for the bond market carnage back then.

Bond market vigilantes are investment managers and other investment professionals who take matters into their own hands when they feel governments and regulators aren't doing their jobs. And because they control so much of the bond market, they can cause bond yields to rise, whether or not central banks raise their base rates, by buying and selling.

This way, the market regulates itself, rather than the central banks. That sounds like how a market is supposed to work, but the moves they cause can be sudden and large.

Though they've not shown up for a while, there are rumours of some sightings of the vigilantes.

Since Donald Trump was elected, 10-year U.S. Treasury yields have climbed from 1.8 percent to 2.3 percent. That's a move of nearly one-third. And the Fed hasn't even raised rates yet.

Interestingly, back in 1994, when the Fed was hiking rates, the 10-year rate went from roughly 6 percent to 8 percent. That, too, was a move of about one-third.

But this time, the Fed hasn't started raising rates yet. Bond traders, possibly vigilantes, are taking matters into their own hands.

The Fed will likely raise rates on Wednesday, which would be a signal that the U.S. Fed feels the U.S. economy is on the right track. And then there's a very good chance other central bankers at the European Central Bank, Bank of England, Bank of Japan, and the People's Bank of China will also begin to raise rates.

And - this is unlikely but possible - if rates climb suddenly and without warning, the resulting bond market crash may make 1994 seem like a gentle swell compared to the coming tsunami.

All the suppressed financial tension built up since 2008 could unwind in a tornado of falling bond prices as fund managers bail out of their rapidly crashing bonds. And where could they invest instead? In the relative security of a constantly rising global stock market, led by the S&P 500.

Remember, when rates change from 6 percent to 8 percent, it's only a 33 percent change. But, when rates change from 0.50 percent to 2 percent, rates have quadrupled!

And if that happens quickly... it could cause another bond market crisis.

With all his promised infrastructure to pay for, Donald Trump could eventually hint that he wants the Fed to keep rates low so he can issue more U.S. government bonds to pay for it all. But we'll know much more about that come March or April next year.

In the meantime, the bond market is looking like an enormous bubble waiting to be popped. The Fed could provide the explosive pin necessary to pop it.

The normally boring bond market could get a lot more interesting very soon.

Please note: This article was first published in Truewealth Asian Investment Daily on 13 December, 2016.

Kim Iskyan is the founder of Singapore-based Truewealth Publishing. He has spent most of the past 25 years exploring and analyzing global markets. He has been a stock analyst and research director for a big emerging market investment bank, managed a hedge fund, and sold mutual funds to private bankers. He has advised Fortune 50 companies on political risk and helped build stock exchanges from scratch in countries that few people could find on a map. He has lived and worked in ten countries, from Spain to Russia to Sri Lanka to the United States.

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