Spectre of 1994 rides again
Is the ghost of 1994 set to spook the markets 10 years further on? Interest rates are very low, for some bond markets they’ve never been lower, and the last time the Central Banks were in anything like tightening mode is but a distant memory. But 2004 feels different in many ways, and there are enough wary managers who remember the shock of February a decade ago and will surely be well prepared for higher rates if and when they come.
“Although we think that bond yields will move higher, we do not see a 1994 scenario in the making,” says Robeco Asset Management’s Ronald Balk. “One major difference with that bear market was that investors then had large long positions and were totally surprised by the Federal Reserve’s first rate hike in February 1994. We use investor surveys of various brokers and they are all indicating that most of their respective clients are short duration in the US.” Balk goes on to suggest that the investment outlook for US government bonds is bearish for 2004 as a whole, but argues that over the coming weeks interest rates may well move sideways or even a bit lower.
Whilst 2004 may not see a replay of 1994’ stomach-churning bond rout, no one is suggesting that investors can afford to be anything other than very careful and alert. As Morgan Stanley’s US economist, Richard Berner, warns, “history shows that inflection points in monetary policy are often market-shaking events.” Berner goes on to describe how careful US officials will have to be in articulating the ‘exit strategy’ from the Fed’s current stance well before rates are actually moved.
That it matters greatly who says what is reflected in the market’s recent morning reaction to comments, the previous night, from Alan Greenspan who suggested that Fed funds could stay at 1% for many months, if not a year. Cue rapid and sizeable rally at the short end. “The Fed has enough credibility for us to believe that Greenspan means what he says,” asserts Bank of Ireland Asset Management’s Niall O’Leary. “And what the Fed is focussed on is the output gap and employment growth, neither of which appear to be set to push up inflationary pressures.”
O’Leary goes on to describe the surprise that many investors feel with interest rates that have remained so low in the face of such robust economic growth in the US. “It’s a difficult phenomenon. US Q3 growth came in at an annualised 8% and then at the end of the year we read that the ISM survey came in at a 30 year high! Yet we still have 10-year US Treasuries at about 4% and a consensus forecast of US GDP growth of 4.5% for the year! A fair value based on real economic growth and inflation ought to put 10-year yields at say, 5% or perhaps nearer 6%. The very low level of Fed funds is clearly a very strong support to the bond market.”
Looking ahead, O’Leary and his colleagues believe the price action of the US bond market will continue to be very positive as long as the Fed stays firm to its convictions. “I think we would describe it as a ‘tactical’ investment market for now and possibly the next few months.”
As for interest rate prospects in Europe, the managers at Robeco agree with the forward markets in that tightening will be less aggressive than in the US. “However, we feel that the market is probably discounting too much just now, says Balk. “The ECB has ample reason to be more passive than the Fed: monetary conditions are tighter in light of the Euro’s appreciation; economic conditions are much weaker in the Euro-zone compared to the US economy; and inflation should not be a worry to the ECB with core inflation and service price inflation both in downward trends. ”