A real estate bust battered the banking system and household balance sheets, so the Federal Reserve responded by cutting inflation-adjusted interest rates to their lowest levels in many years. Meanwhile, tax hikes and cuts in government spending retarded recovery. Some savers were able to earn nice profits by using leverage to purchase long-duration financial assets and farmland, while others complained about low rates.
After several years of weak growth and robust markets, the real economy finally started to turn and the Fed switched to tightening mode. Much to the Fed's surprise, bond yields soared and the stock market stopped rising. Many investors lost huge sums of money, and one municipality was forced into bankruptcy thanks to an ill-judged interest rate swap.
While this may sound like a hypothetical story about the near future, it's actually a description of the first half of the 1990s. Some market participants, acutely aware of history, have become increasingly worried about a repeat of the 1994 bond-market bloodbath. The price of the most recently issued 30-year U.S. Treasury has already fallen by more than 5 percent since the beginning of May, while the price of the newest 30-year inflation-indexed bond has plunged by nearly 14 percent. Some worry that these losses will become much larger as the Fed "tapers" its asset-purchase program.
These fears are probably overdone. For one thing, the Fed has been trying to stimulate the economy for years by bidding up the prices of financial assets. This isn't optimal -- and could even be counterproductive -- but it is the declared strategy. William Dudley, the president of the Federal Reserve Bank of New York, explained the rationale in a recent speech:
Our view is that asset purchases work primarily through the asset side of the balance sheet by transferring duration risk from the private sector to the central bank’s balance sheet. This pushes down risk premia, and prompts private sector investors to move into riskier assets. As a result, financial market conditions ease, supporting wealth and aggregate demand.
Ben Bernanke, the Fed's chairman, made the same point back in August, 2010:
The Fed's strategy relies on the presumption that different financial assets are not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration.
In other words, the Fed isn't going to undo all of its hard work by deliberately inflicting trillions of dollars of losses on the owners of long-duration assets.
Still, it's possible that the Fed may make some temporary mistakes that could create a great deal of short-term market chaos. That's essentially what happened in 1994. Many traders (such as Michael Steinhardt, as described in Sebastian Mallaby's "More Money than God") had used leverage to magnify their bullish positions in long-term Treasury bonds. As the Fed began raising rates, relatively small losses cascaded and forced the traders to dump their holdings en masse. The resulting fire sale caused newly issued 30-year Treasury bonds to lose more than 21 percent of their value, and pushed up benchmark borrowing rates by more than 2 percentage points. Those losses were erased by the end of 1995, however.
Many of today's fixed-income investors will probably be fine, as long as they are willing to hold to maturity. Most long-term securities were yielding significantly more than the market's current expectation for long-term inflation (2.4 percent each year for the next three decades) when people actually bought them. That means they have probably locked in a positive real return, even if they may have to endure a fair amount of volatility in the short run.
(Matthew C. Klein is a contributor to the Ticker. Follow him on Twitter.)