Back to the ’90s: Will rate hikes hit bonds as hard as 1994?

Concern about the speed of US rate rises continues to haunt bond markets, but a 1994-style crash is a ghost that can be laid to rest, according to Adrian Hull, co-head of fixed income at Kames Capital.
US short-term rates have risen five times since December 2015 to a range between 1.25% and 1.5%. At its January meeting the Fed signalled further rate increases and Jay Powell’s first testimony to Congress affirmed more rate hikes for 2018.
There’s an expectation of three US rate hikes in 2018 but concerns that the Fed will move even faster have resurrected the spectre of 1994 – when rates bounced and bond values plummeted.
“The bond market’s memory is arguably short. But 1994 remains vivid as the last time interest rates were raised in an aggressive, systemic fashion led by the US Federal Reserve,” Hull says.
“The accommodation of the early 1990’s came abruptly to an end in ‘94”. In just four months from 4 February 1994 the Fed raised rates by 200bps, shocking bond investors and sparking a sell-off.
“The effect was dramatic, with a near doubling of 2-year Treasury yields to over 7.5%, as Fed Funds moved to 6% from 3% during the year,” Hull says. “Market participants rightly fear a return of such bear sentiment but a re-run is not on the cards,” he says. Hull notes the 90s sell-off was provoked by the Fed’s “shock and awe” approach to t rate rises.
By comparison present policymakers regularly signal their stance, with further rate hikes already reflected in market prices, meaning bond investors can expect some volatility and a longer period of lower returns, but not a collapse in prices.
Hull also points to the deflationary effect companies such as Amazon, founded in 1994, now have on the US economy, limiting the scale of the inflation uptick.
“Now with a market capitalisation of $700bn, Amazon has had a huge impact. It has disrupted and undermined traditional market assumptions across a whole range of sectors from real estate to retailing. As a barely profitable organisation it has grabbed huge market share and decimated inflation.”
Hull adds the North American Free Trade Agreement (NAFTA), signed in 1994, has led to an ongoing cap on US inflation.
Quantitative Easing has also driven rates to historically low levels but the unwind of QE will be a lot slower than the purchasing of those bonds. Hull notes the US budget deficit in 1994 was 2.5% of GDP, with outstanding US Treasury bonds totalling $4.6 trillion. Today the Federal Reserve alone has amassed almost that amount via quantitative easing. “The amount of outstanding Treasury bonds has quadrupled while GDP has only doubled, putting debt to GDP at 100%,” Hull says.