Bond investors are gaining confidence that Federal Reserve Chairman Ben S. Bernanke will unwind the central bank’s unprecedented $3.3 trillion balance sheet without sparking a crash similar to 1994, when Alan Greenspan surprised the market by doubling benchmark lending rates in 12 months.
Though sovereign debt levels have more than quadrupled to $23 trillion, yields for 10-year Treasurys are 5 percentage points lower than they were in 1994 and forward measures show the current 1.74 percent level rising only to 2.04 percent in a year. Policy makers’ forecasts of no rise in the target interest rate for overnight loans between banks until 2015 are damping yields in a market dominated by the Fed’s $1.84 trillion, or 15.4 percent of the $11.94 trillion in marketable U.S. debt.
While BlackRock Inc. is trimming investments in longer-term Treasurys to protect against a rise in yields and Goldman Sachs Group Inc. invokes the memory of 1994, when U.S. bonds lost 3.35 percent as then-Fed chairman Greenspan didn’t prepare investors for the speed of rate increases, money managers from JP Morgan Asset Management Inc. to Fidelity Investments say this time will be different, in part because of Bernanke’s clearer and frequent statements on what would cause central bank policy to change.
“The Fed has been very transparent and their transparency should help offset the risks that were experienced in 1994,” Edward Fitzpatrick, money manager and head of U.S. rates at the JPMorgan unit in New York, which oversees $1.5 trillion, said in a telephone interview April 30.
“There are still hurdles, not the least of which is that they have to end the quantitative easing program before they would contemplate tightening,” he said. “The Fed will have time to craft their message well.”
Yields on 10-year Treasurys, the benchmark for everything from corporate bonds to mortgages, rose to 1.74 percent May 3 after the Labor Department reported the jobless rate fell to 7.5 percent in April, from 7.6 percent the month before, as payrolls expanded by 165,000 jobs. The yield of the benchmark 2 percent note due in February 2023 was 1.74 percent, for a price of 102 9/32, at 8:27 a.m. New York time.
The Federal Open Market Committee said in a statement following a two-day meeting in Washington on May 1 that it will maintain its bond buying at the current monthly pace of $85 billion and is prepared to raise or lower the level of purchases as economic conditions evolve. Policy makers also left in place their statement that they plan to hold the target rate around zero as long as unemployment remains above 6.5 percent and the outlook for inflation doesn’t exceed 2.5 percent.
Most Fed officials don’t anticipate raising the benchmark rate until 2015, according to their estimates provided with forecasts released after the March 19-20 FOMC meeting.
Confidence that the Fed can avoid triggering a 1994-style rout isn’t universal.
“I worry now,” Lloyd C. Blankfein, chief executive officer of Goldman Sachs, said May 2 at a conference in Washington. “I look out of the corner of my eye to the ‘94 period.”
Blankfein said investors are complacent due to record low rates for more than four years, and recalled that the market was shocked by the losses caused two decades ago when they went up.
“Rates could rise rapidly for at least two different reasons,” Antulio Bomfim, senior managing director at Macroeconomic Advisers LLC and a former Fed economist, said in a telephone interview May 1. “The Fed could bungle its communication effort and spook the market. Or despite the Fed’s best efforts on communications, the economic data could end up being a lot stronger than what people thought. That one is a little harder to deal with.”
With the central bank’s asset purchases holding down rates, “at some point you are going to have this spring-loaded effect, where once the Fed starts pulling back, maybe you get a little bit of inflation, 30-year yields will say move up 50 to 75 basis points,” Rick Rieder, chief investment officer for fundamental fixed income at BlackRock in New York, said in a Bloomberg Television interview April 29. That “move leaves a real mark.”
Investors buying $10 million in 30-year bonds at 2.83 percent would lose $874,000 if the yield rose 75 basis points to 3.58 percent by the end of 2014, according to data compiled by Bloomberg. The value would decline by $1.2 million if the rate increased this year.
In 1994 the U.S. bond market fell 2.75 percent, the worst annual performance since 1978 according to Bank of America Merrill Lynch index data, as the central bank raised its benchmark rate to 6 percent by February 1995 from 3 percent 12 months earlier. Treasurys posted an annual loss of 3.35 percent, the worst performance until the 3.72 percent drop in 2009, according to the bank’s Treasury Master index.
Government bond yields worldwide were at record lows of about 1.3 percent as of May 2, according to Bank of America Merrill Lynch’s Global Broad Market Sovereign Plus Index. The amount of debt tracked in the index has more than doubled to $23 trillion over the past five years as the Fed, the Bank of England and the Bank of Japan have pumped cash into the financial system. It’s more than four times the $5 trillion in 1996 when data was first collected.
BOJ Governor Haruhiko Kuroda last month pledged to double monthly bond purchases to about 7 trillion yen ($71.8 billion), while the ECB last week decreased to a record low its main refinancing rate, to 0.5 percent from 0.75 percent.
At a March 20 press conference, Bernanke provided the clearest road map on what needs to happen before the Fed trims its monthly bond purchases, while avoiding any hint that a cut is imminent. The central bank will adjust in a “sensitive way” based on several measures, including payrolls, wages and jobless claims, he said.
That’s not how the central bank communicated in 1994.
“As Fed chairman, every time I expressed a view, I added or subtracted 10 basis points from the credit market,” Greenspan said in an August 2012 Bloomberg Businessweek article.
“So you construct what we used to call Fed-speak. Nobody was quite sure I wasn’t saying something profound when I wasn’t. It’s a self-protection mechanism,” he said, “when you’re in an environment where people are shooting questions at you, and you’ve got to be very careful about the nuances of what you’re going to say and what you don’t say.”
Until 1994, the Fed didn’t publicly disclose when it raised or lowered the overnight bank lending rate.
“This Fed, as compared with 1994, is so different in terms of transparency and communication,” Michael Materasso, a senior money manager and co-chairman of the fixed-income policy committee at Franklin Templeton Investments in New York, which oversees about $394 billion, said during a telephone interview on May 1.
“They go to great lengths to make sure you understand what they’re saying. In 1994 what you had to do was refer back to a speech Greenspan gave in October where if you held it up to the light and turned it 45 degrees, well of course it said: ‘We’re going to raise rates in three months.’ That’s not the goal with this Fed.”
When the central bank begins raising rates, short-term bonds and floating-rate notes, whose yields reset periodically, will be attractive, Materasso said.
“Part of the 1994 bond market sell-off was really a policy error,” Gemma Wright-Casparius, who manages the $43.2 billion Vanguard Inflation-Protected Securities Fund at Valley Forge, Pennsylvania-based Vanguard Group Inc., said in a telephone interview May 1. “The Fed at that time was very bluntly moving the Federal funds rate and the communications strategy was not as efficient as it is now.”
With bond yields at historic low levels for company securities as well as those sold by the Treasury, investors can expect “poor returns,” of about 1 to 2 percent, she said.
Concerns about future inflation propelled increases in long-term Treasury yields when the Fed raised rates in past cycles, Michael Gapen, director of U.S. economic research at Barclays Plc in New York and section chief of monetary and financial markets analysis at the Federal Reserve Board’s Division of Monetary Analysis from September 2008 through April 2010, said in a telephone interview April 29.
That’s less a threat now, as more than half the world economy, including the U.S. and the euro area, is experiencing inflation below the central banks’ desired levels as growth slows and commodity prices slide, according to Bank of America Corp. Consumer prices rose 1.3 percent in February from a year earlier, according to the Fed’s preferred gauge of inflation, matching the lowest level since October 2009.
Whether yields rise quickly or slowly when the Fed begins to remove accommodation “is the key debate in the market at the moment,” Zach Pandl, a senior interest-rate strategist in Minneapolis at Columbia Management Investment Advisers, which oversees $340 billion, said in a telephone interview on April 30.
“The Fed is working very hard to improve the clarity of their communication, the transparency of their policy and they’re particularly worried about avoiding a repeat of 1994,” William Irving, a Merrimack, New Hampshire-based money manager at Fidelity Investments, which oversees $1.6 trillion, said in an April 30 telephone interview.
“The market is concerned enough about it and is focused enough about it that I think this reduces the likelihood of it happening,” Irving said. “If people are super-focused on a risk, chances are, that risk doesn’t materialize — something else that surprises people is what materializes.”
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