When the Federal Reserve last embarked on a series of interest rate increases primarily to ward off inflation, in 1994, the scale of tightening ended up being so aggressive it rocked the U.S. bond market to its core.
Investors were at first sucker-punched by the Fed’s decision to tighten, then floored by how far interest rates rose. Bond yields soared all the way through the cycle as the Fed struggled to control the back end of the curve.
The bond market rout of 1994 is unlikely to be repeated in 2022. Rate rise ‘liftoff’ will be anything but a surprise, and investors simply don’t believe the Fed will reach its projected terminal rate around 2.5%.
But that doesn’t mean there are no lessons to draw on.
There have been three Fed tightening cycles since 1994 but none was aimed primarily at tackling inflation, which is why the one looming into view can be held up against 1994.
For the first time in decades, the Fed is now facing an inflation problem. Pandemic-fueled supply chain shortages and logjams have helped lift annual inflation to 6.8%, the highest since 1982. This will subside, but the Fed is worried it becomes entrenched and sparks a wage-price spiral.
The yield curve flattening today is similar to the months preceding the 1994 hiking cycle, suggesting policy tightening will choke economic activity. But a crucial difference is the 10-year yield, which rose in 1994 but is now drifting lower.
If a rising 10-year yield is a warning sign that the bond market fears inflation expectations may become unanchored, a falling yield surely indicates the opposite.
Certainly, inflation expectations measured by breakeven rates on Treasury Inflation-Protected Securities and five-year forward inflation-linked swaps have fallen from November’s multi-year highs.
So far from the Fed being ‘behind the curve’ - as was assumed in 1994 - market pricing today suggests the Fed may actually be overly aggressive in its outlook, and too far ahead of it.
CREDIBILITY
In early 1994 annual inflation was a fairly benign 2.5%. But policymakers fretted that a strong economy and labor market posed a “distinct risk” to prices (faith in the Phillips curve was stronger back then).
The Fed doubled the federal funds rate over the next 12 months to 6% - at one point executing a 75-basis point hike - and the 10-year Treasury yield soared around 200 basis points. Current money market futures pricing points to a terminal rate no higher than 1.75% over next 5 years.
That is comfortably below the end-2024 indications from the median of Fed policymaker ‘dot plot’ forecasts of 2.00%, and the Fed’s estimate of a longer-term ‘neutral’ rate of interest of 2.5% - a theoretical rate where it sees the economy at equilibrium with stable inflation.
Despite the aggressive tightening in 1994, the S&P 500 only fell 1.5% and the economy grew by 4%. The next recession would not occur until the next decade, and after the next tightening cycle.
Few would predict such a benign outcome today. After decades of rising debt levels, especially the 13 years of post-GFC monetary largesse, and an ageing workforce, the economy and financial markets are more sensitive to rising interest rates than they have ever been.
Even small hikes could have outsized effects, so the fragility of financial markets may keep the Fed in check. The clear risk is if the Fed takes a leaf out of Alan Greenspan’s 1994 play-book and plows on regardless.
“If your credibility is being questioned, you have to surprise. Maybe the market will have to finally respect that the Fed is going to raise rates above 2%,” said Priya Misra, head of global rates strategy at TD Securities.
EYES WIDE OPEN
That may yet happen. But longer-dated Treasury yields remain stubbornly low.
The generally hawkish central bank mindset of the 1990s, with the inflation scares of a only decade earlier still fresh in the memory, is gone. Decades of low inflation and the global crash of 2008, in particular, have made sure of that.
Quantitative easing has forced banks to buy vast amounts of Treasuries for reserves purposes, and depressed yields mean a 10-year yield of 1.5% is even more attractive to pension and insurance funds, who are natural buyers anyway.
Steven Englander, head of FX strategy at Standard Chartered, suggests that although the Fed’s signaling is clear, it might be coming too late. By the time it starts raising rates next year, inflation is likely to have peaked.
“In 1994, the market believed the Fed. There was no doubt that the hiking cycle was gong to persist. Everyone has their eyes wide open here, but maybe the Fed has got the timing wrong,” he said.
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.