All eyes on bonds as Federal Reserve poised to unwind stimulus

I was researching bond prices for a graph we ran in the paper last week and came upon 1994. It was a year which Fortune magazine dubbed as the "great bond massacre". Out of the blue, and prompted by the US Federal Reserve Board starting to increase interest rates for the first time in six years, bond markets collapsed, investors lost a pile of money and number of high-profile hedge funds went down in flames.

Now we are again at the start of a new US interest-rate cycle, as the Federal Reserve Board will almost certainly announce an increase in its key interest rate this week , the first since 2006.

The Fed aggressively slashed rates through the crisis, bringing them to a historic low, with the benchmark Fed funds rate set at 0 to 0.25 per cent.

Free money

The era or free money is now going to come to an end, and there can be no guarantee that it will all go smoothly.

Already there are signs of stress in the US junk bond market – the market for higher yielding corporate debt.

Worries that companies have borrowed too much and will suffer as interest rates rise has contributed to a couple of high-profile funds which invested in corporate debt having to block investor redemptions and some funds being liquidated.

Just this weekend a company called Stone Capital had to block investor withdrawals from a $450 million high yield fund. A small rise in US interest rates may not, of itself, make much difference. But sometimes, as happened in 1994, moves like this can focus attention on areas where markets are vulnerable and investors are already edgy – and highly borrowed companies are one such area.

The 1994 experience is instructive because it shows how quickly markets can turn – and US markets are moving into a jittery period. Any sign that the Fed is moving too far, too fast on rates in 2016 could quickly knock on from the corporate bond markets to equities, where steady growth is already priced in and a minority of analysts are already bearish.

The reaction of the US government bond market remains to be seen. If the Fed is seen as likely to keep recovery on track and hold down inflation, then all could be well. But bonds could be in for some turbulence, too. Never before has a central bank had to unwind such an extraordinary level of monetary stimulus and nobody knows how the re-entry to something more akin to normality can be achieved.

Nor will the nervousness be confined to the US. European bond markets are at extraordinary lows. Ten year Irish bond interest rates are barely over 1 per cent, and many governments, including our own, can borrow for shorter periods at negative interest rates – in others words getting paid by investors who lend them money. If this sounds mad, it is because it is. But so far the threat of deflation, the cut in ECB rates and the massive bond buying programme being undertaken by Frankfurt has kept long-term interest rates on the floor. If, as 2016 goes on, the ECB is right when it says growth may be reviving and inflation may follow, then could European bond markets turn, too?

We are in an era of super low rates which will not continue forever. That said, the deflationary impact of collapsing oil prices are a factor too, and the massive ECB bond-buying programme will remain in place for another 15 months at least.

Long, long time

Then there are the so-called emerging markets. Here the fears are straightforward.When US interest rates were on the floor, billions of dollars were invested in emerging markets as big US funds sought an interest-rate return overseas.

Now, as US rates start to rise, the risk is that the money starts to go home. This has already been reflected in a a sharp fall in emerging market currencies, though lower oil and commodity prices have been a bigger factor here in many cases. But the reaction of emerging economies and currencies is a key thing to watch .

Maybe the rise in US rates will be greeted with a shrug – after all it has been a long, long time coming. But 1994 showed just how momentum can take hold. The unwinding of the most extraordinary monetary stimulus in history is worth watching.