The bond market of 1994

by George Hatjoullis

US Treasury 2 year yield back to 1990SPX1960s

Veiled references to the bond market of 1994 have become common in recent weeks. I have vivid memories of this year as a ‘rates’ trader. It was not much fun. After a sustained bond bull market ( falling interest rates for the unfamiliar) even the tea ladies had long positions (bets on interest rates falling further) by the end of 1993. A discussion with an ex-colleague at a different house at the time, also a rates trader, revealed I was not the only one that felt a sense of unease. The positions were very skewed and a euphoric complacency was evident.

On February 4, 1994, the US Federal reserve raised the federal funds rate by 25 basis points. Many, notably in London, were positioned for a reduction in official sterling interest rates (which in fact materialised on 8 February). All bond markets began to sell off simultaneously. There were no buyers, only sellers. The market makers attempted to forestall selling by moving bids down sharply but such was the panic that all bids were hit. The intraday price moves were extraordinary and violent. So much so that it was hard to even sustain short positions. The problem was exacerbated by the existence of very highly leveraged structured products that required continuous hedging. There was extraordinary negative convexity in the system; the lower prices went the more traders had to sell to hedge. The bond markets failed. Losses were dramatic on some desks. All this was triggered by a 25 basis point rise in the US federal funds rate.

Of course, the federal funds rate move was merely the match that lit the bonfire. The combustible material had been piling up for several years. The parallel with the present situation cannot be lost on anyone that was unfortunate enough to experience 1994 as a rates trader. The first chart above, taken from the US Treasury department website, is of the yield on the two-year treasury note. It rose from around 4% at the start of 1994 to over 7% by the end of 1995. Over the same period the S&P 500 rose over 30%, with all of the rise coming in 1995. In 1994, the S&P 500 ended little changed. Indeed, if one studies the (not terribly clear) charts above one might conclude that, apart from very recently, rising yields tend to coincide with increases in the S&P 500. For example, between 2003 and 2007, the 2 year note yield rose from around 1% to over 5%, and yet the S&P 500 rose continuously over this period by about 60%.  The period from 2001 to 2003 shows a sharp fall in yields, and yet the S&P 500 falling.

So what do you conclude from this little excursion into history? If we attend to the warnings of the FSA we can conclude little, as the past is no guide to the future. However, we can challenge the implicit fears in many of the 1994 discussions, namely that a bond bear market will necessarily be bad for equities. An appeal to history will not support such an assertion.