March 19, 2013 6:32 pm
Markets: The ghosts of ’94
By Michael Mackenzie, Robin Wigglesworth and Stephen Foley

Nineteen-ninety four. Nelson Mandela was inaugurated South Africa’s first black president. Ace of Base dominated the pop charts on both sides of the Atlantic. And Pulp Fiction introduced “Royale with cheese” to the vernacular. On Wall Street, 1994 was the year many money managers lost their shirts.

A sharp, unexpected rise in interest rates wrecked the value of bond portfolios and turned profitable trades into money losers. Hedge funds blew up, banks plunged into the red and the resulting shockwaves even hurt the equity market, which reversed a strong start to end down on the year.

It was, in other words, a year for investors to forget. But it is also a year that is important to remember. Today, with interest rates at rock-bottom thanks to the US Federal Reserve and other central banks, some bond market veterans are hearing echoes of 1994. What will happen, they ask, when the Fed decides it has done enough to stimulate the economy? Could there be another shock? Richard Tang, now head of North America sales at RBS Securities, recalls the “gigantic roar” that went up across the trading floor at Salomon Brothers on February 4, 1994, when the Fed unexpectedly raised rates.

“I remember 1994 very well, clearly like it was yesterday. It was my first bear market in the business,” he says.

The Fed kept tightening through the year, as the US economy picked up steam and the central bank decided to put down a marker against inflation. Traders who had loaded up on debt, notably in mortgage securities, were squeezed, and the leverage in the nascent securitisation market meant the pain was magnified.

US bond yields and Federal Reserve target rate


“It was Armageddon,” says Paul Griffiths, head of fixed income at Aberdeen Asset Management. Everyone got crushed heading towards the exit at the same time.”

The bond rout claimed some powerful names. There were big trading losses at Goldman Sachs, leading Stephen Friedman to step down as its senior partner. Askin Capital Management was the largest hedge fund casualty, while Steinhardt Partners, the successful hedge fund run by Michael Steinhardt, was also hit hard.

Orange County, California, declared bankruptcy after losing money on a derivatives bet. Bankers Trust, the pre-eminent derivatives bank at the time, became trapped in a nasty war with its customers, including Gibson Greetings and Procter & Gamble, over inappropriate derivative investments foisted on them by aggressive traders. A trading scandal at Kidder Peabody was exposed during the rout, resulting in the storied firm being sold to Paine Webber.

Many investors had been lulled into a false sense of security that rates would remain quiescent. This was in some ways understandable: the Fed’s February rise was its first in six years. Until then, the central bank’s prescription for the sluggish economy – whose poor performance had cost President George H.W. Bush the White House – had been a long period of low interest rates, designed to nurture a recovery for the banking system and the housing market.

Not everyone felt so secure, however. Henry Kaufman, the former chief economist at Salomon Brothers, whose pronouncements moved bond markets, had warned that a change in Fed policy could quickly cascade through the financial system.

“There was at the beginning of the nineties a very slow economic recovery,” he recalls. “The economy was labouring to get going. The banks were recovering from a financial crisis. The financial market had already become significantly securitised, the junk bond market had become bigger, the derivatives markets were burgeoning. There were in the early nineties a few analogies to the current period – a few.”

In his State of the Union address that January, President Bill Clinton laid out a compelling argument for why the US economy was finally beginning to wake up. Auto sales are way up. Home sales are at a record high. Millions of Americans have refinanced their homes. And our economy has produced 1.6m private sector jobs in 1993, more than were created in the previous four years combined.”

Bond investors weren’t quite so convinced and they discounted the prospect that Alan Greenspan’s Fed would begin to raise rates in the face of an improving economy.

The question today is whether low interest rates, signs of stability in the housing market and improving jobs data are a prelude to a stronger rebound for the economy this year.

Today’s traders and investors are keenly sensitive to the Fed’s latest thinking on monetary policy, thanks in part to more open communication from Mr Greenspan’s successor, Ben Bernanke. Now it telegraphs the evolution of its thinking through policy statements, minutes of meetings and countless speeches. Nineteen years ago, it didn’t always even announce rate changes. Markets react instantly on any clue as to when the central bank might finally signal its intention to wind down quantitative easing.

“The market, justifiably so, is constantly nervous about a rate sell-off,” says Mr Tang. “These artificially manipulated rates by central banks make people nervous and they are uncomfortably long equities and credit. We have never seen a major central bank exit QE and you can’t say fears among bond investors are not justified.”

The state of nervousness could be read as a positive sign of a determination not to be taken by surprise again.

. . .

There has been one big rate tightening cycle in the intervening years, after the end of the early 2000s recession. From June 2004, the Fed implemented 17 well-telegraphed rate increases, pushing the funds rate up in quarter-point increments to 5.25 per cent, without crippling the bond market.

“We are talking about two very different eras,” says Mr Tang. Jurassic versus Prehistoric is how I would define how the bond market has developed since 1994. That was an era of imperfect information. We just had green screen terminals with bond prices. You had to go and seek out your economist’s opinion to find out what was happening. I had no email, no Bloomberg terminal. There was nothing like the proliferation of information that we have today.”

Compounding the adverse reaction to Fed rate increases in 1994 were some important aspects of the bond market’s structure. For the first time, bond investors had to understand how mortgage securities would seriously underperform and lose money for investors as underlying interest rates rose. This time the Fed may have the tools to curtail a rise in bond yields.

So it is different this time. History cannot repeat itself. But will it rhyme? Much the same way as the Black Monday crash of 1987 now looks a blip on a chart of the equity market of the past 30 years, the interest rate rises of 1994 barely register on a long-term graph. Since Paul Volcker, Fed chairman at the start of Ronald Reagan’s presidency, licked inflation with viciously high rates, the trend has been almost relentlessly downward, until the 2008 financial crisis and the era of zero per cent short-term rates.

The scale of the current bond bull market means that its end could be far more serious than anything seen in 1994.

Apart from the distorting effects of Fed bond buying on the Treasury market, there has also been a change in the size of interest rate-sensitive markets since 1994. The value of outstanding bonds$37.7tn at the end of September 2012 – is three-and-a-half times what it was 19 years ago.

There are vastly more hedge funds and ordinary investors who own bonds now, and money going into bond funds has accelerated sharply since the crisis, according to Lipper, the data provider. Inflows reached $309bn in 2012, taking the total to more than $1tn since 2009.

The emergence of exchange traded funds means that it is easier and cheaper than ever for investors to bet on movements in the bond market. Inflows into bond ETFs rose to $51.4bn in 2012, up from $12.7bn in 2007. And the market for interest rate swaps has also ballooned, with the face value of these instruments now over $500tn. These can help investors offset the damage from sharply rising interest rates. They can also help aggressive investors bet profitably on such a development, thereby exacerbating any future sell-off.

William Strazzullo, chief market strategist at BellCurve Markets, who 19 years ago was trading short-term interest rates for Paine Webber, says today’s investors will look to sell bonds to ride yields higher, potentially fuelling an overshoot.

“If it gets going, it will take on a life of its own,” he says. “In 1994, most people were in their cubby hole focusing on one specific area, whereas now there are a lot more people willing to jump on a trend. People are salivating at the idea of the bond bubble ending and the move to higher rates will be explosive. It will be worse than 1994.”

One person with plenty of experience of rising rates is Dan Fuss, the vice-chairman of Loomis Sayles, who has been investing in bond markets for more than 50 years. He says that “no one knows the future” but warns that investors are “probably at the foothills of gradually rising rates, ahead of a mountain of high rates”.

The Fed has promised to hold short-term rates as close to zero as possible until US unemployment has fallen from today’s rate of 7.9 per cent to 6.5 per centsomething that could take another two years.

What the central bank wants to see is a period where long-term rates go up first, as the economy improves, before it raises the cost of short-term borrowing. That way banks and other financial firms can still make money by borrowing cheaply and lending it out at higher rates. Most of all, it wants the shift to higher rates to come slowly.

Mr Bernanke has not been quiet about the prospect of higher long-term bond yields and the risk that a sharp jump will inflict capital losses on bond holders and financial institutions. Citing the 1994 experience in a speech on long-term interest rates, Mr Bernanke says the central bank provides far more clarity about its policy intentions and could act to stem a sudden rise in rates.

As in 1994, it could be the strength of the economic recovery that is the wild card. Strong employment data in March, 1994, accelerated the stampede out of bonds. Today, the risk is a big uptick in job creation that hits the Fed’s unemployment target before the market is ready.

Rick Klingman was at the centre of the storm in 1994, as he traded for Yamaichi International in New York. “It’s hard to convey just how hard people got crushed by the rate hikes and higher yields across the bond market,” says Mr Klingman, now with BNP Paribas. “There was total dislocation. No one in ’94 was prepared for the rate hikes and a lot of people got exposed by the severity of the Fed’s tightening that year.”

That was 19 years ago and there are not that many traders left who have felt the lash of sharply tighter monetary policy. That is a warning sign for Mr Klingman. “The bond market today is full of people trading who have not encountered an aggressive rate tightening cycle.”

Copyright The Financial Times Limited 2013.


March 18, 2013, 7:09 p.m. ET

How the House Budget Would Boost the Economy

Slowing federal spending will alleviate fears of higher future taxes, spurring more investment and consumption.



This week the House of Representatives will vote on its Budget Committee plan, which would bring federal finances into balance by 2023. The plan would do so by gradually slowing the growth in federal spending without raising taxes.

Still, the plan has been denounced by naysayers who assert that it would harm the economic recovery and that, at the least, any spending reductions should be put off until later. This thinking is just as wrong now as it was in the 1970s.

According to our research, the spending restraint and balanced-budget parts of the House Budget Committee plan would boost the economy immediately. With the Budget Committee's proposed tax reform included, the immediate impact would be even larger. The entire plan would raise gross domestic product by one percentage point in 2014, equivalent to about a $1,500 increase for each U.S. household. Ten years from now, at the end of the official budget horizon, we estimate that the entire plan would raise GDP by three percentage points, or more than $4,000 for each U.S. household.

Our assessment is based on a modern macroeconomic model (developed with Volker Wieland of the University of Frankfurt and Maik Wolters of the University of Kiel) whose features include a recognition that the resources to finance government expenditures aren't free—they withdraw resources from the private economy. The model provides for other essential attributes of the economy—that consumers, businesses and workers respond to incentives, and they are influenced by their expectation of future economic conditions when making decisions today. None of these features is provided for in old-style Keynesian models.

The House budget plan keeps total federal outlays at their current level for two years. Thereafter, spending would rise each year, but more slowly than if present policies continue. By 2023, federal expenditures would decline to 19.1% of GDP in 2023 from 22.2% today.

Since the Congressional Budget Office projects that revenues will equal 19.1% of GDP in 2023, the House plan will balance the budget that year. Also by 2023, the publicly held federal debt relative to GDP would decline to 55% from its current high level of 76%.

The House budget is hardly austere: The federal spending claim on GDP would still be considerably higher than it was in fiscal 2000 (18.2%) and only slightly below its claim on GDP in 2007 (19.7%).

The reductions in the growth rate of spending are to be achieved primarily through entitlement reforms. The Affordable Care Act would be repealed. Medicaid and food-stamp administration would be turned over to the states.

Medicare would be fundamentally reformed. Anti-fraud measures would be applied to federal disability programs. Among the major entitlement programs, only Social Security would remain unchanged; this is a deficiency in the plan. As for discretionary spending, the House budget plan would provide for only slight reductions from the levels that are set by the budget sequester.

The long-run economic gains from restraining government spending would not, despite what critics claim, harm the economy in the short run. Instead, the economy would start to grow right away. Why?

First, the lower level of future government spending avoids the necessity of sharply raising taxes. The expectation that tax rates won't need to rise provides incentives for higher investment and employment today.

Second, since the expectation of lower future taxes has the effect of raising people's estimation of future disposable income, consumption increases today. This change comes thanks to Milton Friedman's famous "permanent income" hypothesis that the behavior of consumers reflects what they expect to earn over a long period. According to our macroeconomic model, the higher level of consumption induced by the House budget's effect on consumer expectations is large enough to offset the reduced growth of government spending.

Third, the new budget's reduction in the growth of government spending is gradual. That allows private businesses to adjust efficiently without disruptions.

Still, our macroeconomic model likely underestimates the positive impact of the House budget plan. The model doesn't account for the greater economic certainty that results from preventing the national debt from soaring to dangerously high levels and from stabilizing the federal tax burden. Nor does the model account for beneficial changes in monetary policy that could accompany enactment of the budget plan. Lower deficits and national debt would reduce pressure on the Federal Reserve to continue buying long-term Treasury bonds.

The U.S. economy has been experiencing its slowest recovery from a deep recession in modern history. Tragically, fewer people are working as a percentage of the working-age population than when the recovery began—and economic growth was only 1.6% last year. The large federal budget deficits—by increasing uncertainty and delaying private spending—are an important cause of this lackluster economic performance.

For too long, policy makers have been misguided by models that lend support to bigger government or to the politically convenient objective of delaying any reduction in spending. It is better to recognize the flaws in this approach and get on with the sensible budget reforms the country so sorely needs.

Messrs. Cogan and Taylor are professors at Stanford and senior fellows at the Hoover Institution. The macroeconomic model used in their research was published last month in the Journal of Economic Dynamics and Control, with updated results at Hoover's Economic Policy Working Group website.

Gold: The Bottom Is In And We're Going Much Higher From Here

Mar 19 2013, 14:58

by: Dave Kranzler

Gold is about to take out $1,600...We may never see that $1,600 level ever again. - Jim Sinclair on King World News (KWN Interview)

Ahead of tomorrow's FOMC policy announcement, I am calling for a big move higher in gold this week and over the next several months. Given the situation going on with the banking system in Cyprus, I do not think there's any risk whatsoever that the Fed will try to "jawbone" an even somewhat "hawkish" policy announcement, as it would risk losing its only indicator of credibility right now, which is the stock market.

Having said that, I wanted to update all the indicators that are signaling, at least to me, why gold is getting ready to head a lot higher from here.

First, to update the massive Comex gold futures hedge fund short position, as of last Friday's COT report, the "managed money" category - aka the hedge funds - increased their gross position in gold futures by another 1,460 contracts to 68,642. This is an all-time record short position for the hedge funds and it is a staggering 15.4% of the total open interest in gold futures. As I explained here, hedge funds typically do not take delivery of long positions and neither do they deliver gold into short positions.

Based on this, we can safely assume that at critical technical levels the hedge funds will be aggressively covering their short position at least as aggressively as they built it up in order to avoid risking delivery exposure. $1600 is one of those critical technical levels. Historically, the hedge funds who trade gold futures have always been on the wrong side of big moves either way in gold.

Second, the price of gold has substantially "dislocated" from its long-term correlation with the direction of the Fed's Monetary Base. This chart below shows the correlation between the Fed's non- seasonally adjusted monetary base and the price of gold going back to the beginning of 2008:

(Click to enlarge)

As you can see, since gold's last peak in 2011, the price of gold and the direction in the growth of the Fed's monetary base have gone in opposite directions. This trend has accelerated since the end of 2012 and the advent of the latest round of Fed QE ($85 billion per month).

Based on the current QE program, the Fed's monetary base projects out to be at $4 trillion by 2014 - a 31% increase from where it is today. If we assume that gold does a "mean reversion" in its correlation with the Fed's monetary base - a high probability assumption given the high correlation observed since 2008 - a 31% increase in the price of gold as of today - $1610 - would imply that gold has a high probability of going to $2100 by the end of 2013. In fact, I will make that my price prediction for gold for 2013.

Finally, I have been saying for quite some time that eventually the smartest of the big institutions are going to start moving aggressively into the precious metals and mining stock sector. Surprisingly, given the fundamental condition of the global financial system, this has taken longer than I expected.

However, we know that GLD is the largest position in John Paulson's hedge funds. Today it was revealed in an SEC 13F filing that Vinik Asset Management established a huge position in GLD and in some mining stocks during the fourth quarter of 2012: Vinik 13F. For those of you who don't know the name, Jeffrey Vinik is known for being one of the most successful managers of the famed Fidelity Magellan fund. He is known for taking big positions and riding them until they pay off.

As you can see from the link I provided, Vinik not only took a huge position in GLD during Q4, he made it by far his fund's largest holding by market cap. That makes two very well respected and successful hedge fund managers running large funds who have made gold their fund's largest market bet. As many of you know, the NY hedge fund community is very imitative (monkey-see, monkey-do).

I expect that over the next several quarters we'll several more high profile hedge funds take on large positions in gold, silver and mining stocks, which will put substantial upward price pressure on the price of gold.

So, what's the best way to take advantage of this? I've been putting on aggressive positions in GLD in the fund I manage this week. One strategy I like is to short near-money puts, as this enables me to take a position in the underlying but get paid a premium vs. the instrinsic value of the put option, allowing me some "room" to be wrong on my view. If I'm wrong on the price-entry, I take delivery of the underlying at option expiration only I've established a cost-basis in the stock that is below the price of the underlying when I entered the put position. For instance, today I shorted GLD 156 strike puts which expire Friday for 91 cents when GLD was at $156.

If I get delivered, my basis in GLD is $155.09 (strike price less the premium I took in). I have also gotten long GLD at a lower level (last week) and I'm shorting some longer-to-expiration out-of-the-money puts on GLD to collect the premium and possibly take delivery. With the latter, I expect that I will only be keeping the premium, as I anticipate that the price of gold/GLD will be much higher when these short-put positions expire.