If there were a large rise in bond yields, investors would not be cushioned by high bond coupons as they were in 1994, when coupons of 8% were common, compared with 2% or lower

June 7, 2013 6:31 pm

Why bonds aren’t heading for a repeat of 1994

By Jim Leaviss

A more open Fed has given up the power to shock, says Jim Leaviss

Like many bond investors, I  remember 1994  well. I was working on the gilt desk at the Bank of England, and having seen only steadily falling yields in my career,it felt like carnage. But you might be surprised at how modest the losses for bond investors actually were that year. Although the benchmark US interest rate went from 3 per cent to 5.5 per cent, the US Treasury Bond index saw losses of just 3.2 per cent. These were recouped in spades in 1995, when Treasuries returned 18.6 per cent. Many investors see strong parallels between the situation in the US back then, and today. After years of fantastic returns for bond investors, could the Federal Reserve be thinking of raising rates, or exiting itsquantitative easing programme? However, the situation today is different. On the negative side, if there were a large rise in bond yields, investors would not be cushioned by high bond coupons as they were in 1994, when coupons of 8 per cent were common, compared with 2 per cent, or lower, today. So total returns for today’s bonds for the same rise in yields would be much less.But on the positive side, the Fed has willingly given away its ability to surprise the market. The first rate increase in February 1994 came out of the blue. Back then, there were no press conferences or Open Market Committee minutes. Investors were operating in an environment of significantly less information and transparency about monetary policy.

Since the financial crisis, Ben Bernanke’s Fed has taken the view that giving markets the certainty that rates won’t go up unexpectedly is a necessary condition for economic recovery. In December last year, for example, Bernanke linked any rate increase and tapering of quantitative easing to explicit improvements in the labour market. At current rates of job creation, this all but rules out any change in US rates for at least a year, and perhaps much longer. This form of “forward guidance” from the Fed (and likely to be coming soon to the Bank of England when Mark Carney arrives) marks the big difference between today and 1994.

I do worry, though, that such “open mouth policies” have robbed central banks of the ability to shock. Shocks, or the possibility of shocks, are important in preventing imprudent lending and investing. Outgoing Bank of England governor Sir Mervyn King once suggested that central bankers should behave like Diego Maradona as he scored his wonder goal against England at the 1986 World Cup. Maradona ran directly at the England goal, but because of the way he jinked his shoulders, head and eyebrows, defenders could never be sure that he wasn’t going to change course suddenly. If inflation increased to, say, 5 per cent, yet employment growth remained sluggish, the Fed would have to decide whether to give up its power or its credibility.

Even if the Fed hadn’t tied its hands to easy monetary policy for years to come, there are other reasons it won’t raise rates soon. Low, but rising prices, make buying a home attractive again, and low levels of inventory mean that any increase in demand will have a big impact on house building, creating hundreds of thousands of jobs.

A big rise in mortgage rates could bring the building recovery to a halt.

Second, the US has so much debt maturing within the next few years that any rise in its bond yields could lead to the interest costs becoming unsustainable.

So if yields rise the Fed has to step back in with either words or action. For the foreseeable future, it is trapped in a quantitative easing “feedback loop” which is increasingly difficult to exit.

Jim Leaviss is head of retail fixed interest at M&G Investments