On the 20th Anniversary of the '94 Bond Crash, Another One?
Last week's selloff in the Nikkei was a reminder that markets remain frail and vulnerable to any hint of a shift in policy and/or an improved trend that will interrupt the recurring quarters of central bank's monetary expansion. Profit taking marked a nervous boundary and a rejection of further risk at this time, although not for long.
The U.S. has led the economic recovery that built the trajectory for this rally in equities, and the yield contraction that has been sustained while preserving benign levels of government-measured inflation. Japan confused the currency markets by deliberately weakening the Yen with an eye toward always illusory export advantage. Forgotten is that Japan's greatest export era was the ‘70s and ‘80s when the Yen crushed the dollar along with just about every other major foreign currency. China has invoked a bold, but conflicting set of policies that inflated asset prices with ample availability of credit, yet none of this kept the PMI from falling below 50% last week, compromising the rising nation's growth forecasts and ability to service their outsized credit expansion.
Among the key developed economies in Europe and the U.S., debt loads have contracted and manufacturing prospects have improved thanks to a collaborative effort to modify domestic labor costs. If U.S. employment and GDP data accelerate in the quarters ahead, the Fed's monetary and inflation targets may be met earlier than forecast such that the central bank can prematurely interrupt the artificial support mechanism that has absorbed trillions of dollars in government issuances. Investors will be challenged against the market forces that efficiently realign global interest rates, credit spreads and FX yield differentials that compete for capital and influence the current account and GDP. A stronger than forecasted economic rebound may leave investors unprepared to deal with a similar scenario we experienced in 1994, with a premature and unanticipated rise in rates and a diminished capacity on the Fed's balance sheet.
Next year will mark the 20 year anniversary of the bond market fallout of 1994, which many market participants from that era still view as one of the most damaging of all previous financial crises. Interest rates rose abruptly and consecutively for several quarters, triggering a massive global sell off of fixed income securities and other financial products in a frantic effort to de-lever balance sheets and satisfy margin calls. Hedge funds were liquidated, pension funds and insurance companies experienced significant losses in their bond portfolios, and retirees lost considerable principal while holding U.S. Treasuries. Will the Fed's targets be achieved too quickly, as soon as next year, and the needs for transitory central bank subsidies disappear? The likelihood remains high that a similar crisis may resurrect itself and threaten the contingent element that provides liquidity for the capital dependent financial society we are. 2014 may become a sobering anniversary with no cause for celebration.