Saturday, 11 May 2013

1993 all over again, not

A brief history of the Fed's exit from mad money in 1994... 

My aim when blogging is not to write the kind of "research" that I'm paid to produce for my employer and definitely not to send out anything that could possibly be construed as an investment recommendation. This piece is a response to questions I get asked fairly frequently about how the US Federal Reserve exited from its first period of monetary madness in 1994, when after leaving interest rates at 3% for a long time they shocked the world by moving them up to 6% over the course of 12 months. That send bond yields sharply higher and sowed the seeds of the Asian financial and economic crisis as countries which had "imported" excessively easy US monetary policies thanks to pegged exchange rates found themselves with excessive (private sector) debts in both local and foreign currencies.

There are four charts in the box below, three showing how 1994/1995 unfolded and the fourth showing the current period for some kind of reference.

The top left chart shows the Fed Funds target rate (in green), the 3-month US dollar rate and the 4th Eurodollar futures contract, expressed as a rate. The 4th Euro$ contract reflects the rate market participants will trade for 3-month rates in roughly 12 months' time (the contracts have expiry dates in March/June/Sep and Dec, so on Jan 1 the 4th contract is the December one, and in April it is the one for the following March, and so on). I use it because 20 years ago, this was already a very well-established and liquid instrument for trading interest rates.

1994 started with Fed Funds at 3% and the futures market pricing an increase of roughly 1% over the following year. That premium had been gradually eroded through 1993 as an extended period of low rates forced anyone betting on an earlier hike to capitulate (sound familiar?). Two things leap out - the entire rate-hiking cycle was priced into the futures market by mid-year (when 3-month futures rates got above the eventual peak in actual rates) and the market went on to dramatically over-price the eventual policy rate peak. Remember, the previous peak in rates had been just shy of 10%, so market participants were wary of how far the Fed might have to go.

The top-right chart adds the 10yr Treasury yield and the S&P 500 index to the picture. The S&P drifted lower in the fist half of 1994 as rates and 10yr yields rose pretty sharply. The second half of the year saw a further sell-off in the bond market while the equity market meandered sideways. Stock markets didn't know whether to fear higher rates or welcome economic recovery. By the end of 1994 however, well before the eventual peak in (Fed) rates, 10-year Note yields had peaked, as had the rate implied by the Euro-dollar futures contracts. That was the signal for a long bull market to start in the equity market. It was clear both that the economic recovery would not be undermined by tighter policy and that the peak in rates would be very low by (recent) historical standards.

The bottom left chart shows how the Dollar Index traded through this period. I've really only included this as a warning to anyone who thinks currency markets follow stable rules. The dollar went down as US rates rose through 1994 (partly because the bond market sell-off saw capital flow out of the country  in particular being repatriated to Japan, partly because the US current account deficit was growing). The dollar only started to move higher in the spring of 1995, once the unrest from the bond market's gyrations was over, the yen had become unsustainably strong, and the out-performance of the US economy sent both currency and US equity market on a long march higher that lasted for pretty much the rest of the decade. Those who are bullish of the outlook for dollar in the years to come reference this period because once the Fed has to some degree 'normalised' policy in the wake of improving economic conditions (over the next couple of years) there will be some pretty powerful similarities with the 1995-2000 period.

The bottom right chart show the current situation  Fed Funds are at 25bp. Euro-dollar futures price no chance in rates over the next twelve months and I don't know anyone who expects any move. The 10-year Note yield is going up, but the 2 1/2% gap between Fed Funds and 10-yr yields at the start of 1993 is 1 1/2% now. We are either complacent or we are more confident about how the unwinding of US monetary accommodation plays out: believing the eventual peak will be far lower than in the past partly because this is a new-normal sluggish recovery and partly because  total (private and public sector) debt levels in the US economy are too high for an old-fashioned rate cycle.

I think the US economy is showing signs of life as a weak dollar attracts jobs back from abroad, as healthier banks and low rates ignite a housing recovery, as bumper profits finally start to turn into some capital spending by companies. I don't think that means the Federal reserve will hike in the next 12 months however.         But I do think that one similarity with the mid-1990s is valid - that the US will be to a significant degree indifferent to the external impact of policy decisions.  Moving towards energy independence must make US policy makers more focused on the US and less on the rest of the world in a range of ways. The European crisis has certainly played a part in US policy-making of late but calmer markets (even if disaster still lurks below the surface) will also allow a more US-centric focus. The US was indifferent (or oblivious) to the Asian bubble as it grew in the early 1990s and largely indifferent to it when it burst at the end of the decade. I can't see concern about how unwinding easy money in 2014/2015 affects everyone else being very high on the Fed's list of priorities.

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