Almost 30 years on, the great bond massacre of 1994 still looms over Wall Street.
So when Federal Reserve Chair Jerome Powell pitches 1994 as the model of what he’s trying to achieve in this interest-rate cycle, it’s enough to cause shivers on trading floors. “In three episodes,” he observed in a recent speech, “in 1965, 1984 and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession.”
Like today, the Fed in 1994 was anxious about a potential buildup of inflation pressures. Led by Alan Greenspan, policy makers that February raised the benchmark rate for the first time in five years, moving by 25 basis points. They added another 275 basis points in the following 12 months, topping out at 6%
On Main Street, Greenspan’s strategy was a success. Inflation was held in check, and the economy grew by 4%. The next recession didn’t occur until the following decade.
But the episode sent Wall Street reeling. The initial rate hike came as a shock and led to an increase in financial market volatility as rate expectations shifted rapidly. According to some estimates, capital losses across world bond markets came to $1.5 trillion—equivalent to almost 10% of OECD countries’ gross domestic product.
Bond funds including Pimco and BlackRock were hit hard—Pimco’s 1994 performance still ranks as its worst in history. Trading shops fared worse. Revenue at Bear Stearns and Bankers Trust, two bond-oriented firms, was down more than 20%. Revenue at Salomon Inc. (now part of Citigroup Inc.) fell by two-thirds. “Your company’s 1994 results were awful,” admitted the firm’s chairman in his annual shareholder letter. “With these results, every non-comatose shareholder must be wondering whether management understands the business situation of Salomon Brothers… in other words, does management know what it is doing?”
While a number of Wall Street executives will likely remember the events of 1994 clearly, few will have been active on trading floors during the other episodes Powell mentioned—1965 and 1984. Neither were any more favorable for traders.
Under Chairman Paul Volcker, the Fed began raising rates in May 1983, increasing them by 315 basis points over the course of the cycle. In a taste of what was to come 10 years later, trading firms were blindsided. In the second quarter of 1984, pretax profits in the securities industry fell to around $150 million, from $1.46 billion in the quarter the rate tightening cycle began. In the 12 months following the first rate hike, Salomon Brothers’ stock was down 62%.
Similarly, in 1965, the cycle didn’t cause a recession but it did prompt a credit crunch in the summer of ’66 characterized by disorder in the market for state and municipal bonds. The Fed was forced to enter as a lender of last resort to save the muni market—a role it would reprise in various other sectors in years to come. Securities firms weren’t yet public – they were mostly structured as private partnerships—but bank stock prices fell by about 30%, underperforming the overall index.
Clearly, a lot has changed since these prior periods. Before 1994, the Fed barely communicated its actions—the 1994 press release was the first of its kind and even then a cursory four sentences long. In addition, policy makers are more attuned to the impact their actions have on markets. Speaking to the Senate Banking Committee in May 1994, Greenspan said that the Fed “had thought long-term rates would move a little higher temporarily as we tightened.” He underestimated the market’s response.