1994 Has Some Lessons

The sharp sell-off in Government bonds last week has left some investors, so one bond market strategist told the FT last week, “shell shocked at the speed of the rise in yields”. Hmmm: if that is the case, it seems that the investors in question would do well to consider a crash course in financial market history.

A good place to start would be More Money Than God, Sebastian Mallaby’s splendid analysis of modern hedge fund experience, published earlier this year. The chapter on the events of 1994, a year when bond markets cracked in spectacular fashion, is particularly relevant. No parallels are ever precise, but the bond market experience of 1994, which followed directly from the 1990-91 recession, and sowed the seeds of much trouble which was to follow, has been nagging away as an uncomfortable precedent for some time.

1994 was by any standards a tough year in the financial markets.  Not only were banks and hedge fund investors left nursing heavy losses on their bond holdings, but the year also witnessed the near bankruptcy of Bankers Trust (a sort of proto-Lehman Brothers event), the ruination of Barings by its rogue trader Nick Leeson and the unexpected death throes of Warburgs, the great white hope of UK investment banking, which found it could no longer survive as an independent entity.

There were many proximate causes for these events, but the initial trigger was a modest 0.25% rise in US interest rates, settled on at the February 4th meeting of the Federal Reserve’s Open Market Committee. Alan Greenspan’s view was that a modest precautionary hike in short term interest rates would be sufficient to head off inflationary expectations as the US economy continued its recovery from the earlier recession.  He reasoned that while a 0.5% interest rate rise might be unnecessarily unsettling, a smaller increase would help to bring long term interest rates down as the bond markets absorbed this prudent restatement of the Fed’s anti-inflationary credentials.

The market fallout was very different, however, and an early warning that in the fast-moving deregulated global markets which had gradually been developing since the 1980s, reactions to central bank signals could be both more dramatic and sudden than policymakers now realised. In response to Greenspan’s move, instead of rising, bond prices at the long end of the yield curve tumbled, which in turn led to wholesale dumping of bonds in Europe and the Far East, imposing hefty losses on scores of highly leveraged market participants who were positioned the wrong way.

Chief among the victims were some prominent New York hedge funds and the proprietary trading desks of the investment banks, many of whom, Mallaby reminds us, were by then already echoing the behaviour of the “shadow banking” system which was to cause so much trouble in 2007-08. Before the month of February was out, Steinhardt Partners, a hitherto wildly successful hedge fund run by the legendary, irascible trader Michael Steinhardt, had lost $900m as its huge “carry trade” bet imploded.

Stanley Druckenmiller, for many years the right hand man of George Soros, lost $650m in two days, half as much as Soros had made from his famous bet against sterling two years before. Goldman Sachs reported its worst results for ten years. The insurance industry was reckoned to have lost almost as much on its bond holdings as it had paid out on Hurricane Andrew. A newly formed hedge fund set up to trade (what else?) mortgage-backed securities collapsed, causing losses of at least $500 million, barely a year after being established.

The carnage, it turned out, was accentuated by the huge amounts of leveraged capital that were now being deployed in bond market trading. Two hedge funds on their own, it turned out, one leveraged almost 100 to one, effectively cornered the market in one Treasury bond auction. Mr Steinhardt said later that he had never realised his big bond market trade, which ran to billions of dollars, had become so crowded.

While politicians initially turned their rage in the aftermath on the hedge funds, ignoring Soros’ entirely valid point that the people who really needed controlling were the banks and brokerages which had lent so much money so recklessly to traders, the really damaging consequences of 1994 lay in the Federal Reserve’s decision to abandon any future attempts to head off asset price bubbles in favour of its “lets-clean-it-up afterwards” policy, which was to play such an important role later in precipitating the 2007-09 global financial crisis.

Of course there are many differences between 1994 and 2010, but with bond yields already so much lower than they were then, a great 28-year bull market in bonds in its dying throes, and inflationary pressures building, unless leverage and herding behaviour have suddenly become a thing of the past no investor should be surprised to find that bond markets are vulnerable to sharp and painful adjustments, of which last week’s movements are a foretaste.