The Bond Routs That Still Cast a Shadow on Wall Street

(Bloomberg Opinion) -- 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.

Securities firms' business models have also changed markedly. Back in 1994, New York Stock Exchange member firms walked into the tightening cycle with $265 billion of securities inventory on their balance sheet, which unwound to drastic effect. As a result of more recent regulatory requirements around capital and liquidity, as well as market preference, firms tend to facilitate trades on an agency basis rather than act as principal. At the big U.S. banks, trading inventory accounts for around 14% of total assets, down from 23% ten years ago.

Yet while a blow-up may be less likely, underlying trading conditions are far from buoyant. The first quarter is typically the strongest of the year for securities firms – and it's not shaping up that well. Jefferies Group reported its fiscal first quarter results last week for the period ending February 28th. Fixed income trading revenues were down 44% on the year. “Fixed Income net revenues were lower,” a company statement said, “primarily due to lower trading volumes in the face of inflation concerns and interest rate uncertainty.”

For many banks and brokers, last year was a record year. Traders may argue their business is more robust than in 1965, 1984 or 1994, but they operate in a cyclical business. A soft landing for the economy may not mean a soft landing for them.

More From Bloomberg Opinion:

• The Fed Has Made a U.S. Recession Inevitable: Bill Dudley
• Putin's War Has Made Jay Powell's Job Easier: Daniel Moss
• The Fed Faces a Troubling 1965 Parallel: Narayana Kocherlakota

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marc Rubinstein is a former hedge fund manager. He is the author of the weekly Net Interest newsletter on financial-sector themes.

©2022 Bloomberg L.P.