Will a more aggressive Federal Reserve lead to a repeat of 1994’s market turmoil?

“New US Federal Reserve chair Jay Powell’s first meeting in charge on 20-21 March could set the tone for the rest of this year and beyond and investors will be wondering whether he sanctions a more aggressive stance than the markets currently expect.  If he does, that could bring back bad memories of 1994 when the Fed tightened monetary policy unexpectedly. This sent bonds down, put global stocks into a tizzy and inadvertently contributed to a devaluation in Mexico and a wobble in emerging markets.

“Markets now look to be discounting three interest rate increases of one-quarter point each in 2018, starting with next week’s meeting, although Mr. Powell’s views seem to have investors wondering whether a fourth hike, or even a 0.5% increment, could be coming.

Markets are pricing in three Fed rate rises in 2018

Source: CME Fedwatch

“Either of these moves would hark back to 1994, when then Fed chair Alan Greenspan stunned markets with a quick-fire series of interest rate hikes which took the Fed Funds rate from 3% to 5.5%.

“That roiled stock and bond markets in the USA and the world over, even playing a role in the 1994-95 Mexican financial crisis, as higher US interest rates sucked cash out of Mexico, breaking the peso’s peg to the dollar and forcing a devaluation and then interest rate hikes which helped to tip the local economy into a recession so deep that America and the International Monetary Fund swiftly organised a $50 billion bail-out programme.

“UK stocks took offence even though the Bank of England cut interest rates by 0.25% to 5.13% in February 1994. The Old Lady of Threadneedle Street then followed the Fed by tightening policy, via a pair of 50 basis-point increases, to take the base rate to 6.13% by year end.

Performance of major asset classes and stock indices in 1994

Source: Thomson Reuters Datastream

“In sum:

• Stocks did less badly than Government bonds, where rising yields and falling prices in the USA led directly to a huge trading loss at then-leading investment bank Kidder Peabody (and the unearthing of fraudulent trades by Joe Jett) and the bankruptcy of Orange County, California after its investment portfolio, run by Robert Citron, came unstuck.

• High yield debt was a disaster as it fared even worse than Government debt

• Developed equity markets did less badly than emerging ones, although Asia did well and Japan did best of all in the equity arena

• Commodities did well overall, perhaps buoyed by the economic upturn which central banks were seeking to cool, although the havens of gold and silver fared poorly

“History is by no means guaranteed to repeat itself but there were few places to hide.

“The good news is that stocks and bonds did regain their poise, marching powerfully higher from 1995 to 2000, albeit with some turmoil caused by the Asian and Russian debt crises of 1997-98 along the way.

“That was because US (and global) GDP growth held up well, inflation stood in the mid-single digits and corporate profit growth remained robust, so the backcloth was therefore supportive for security prices.

“Whether the environment is quite so helpful today remains a matter of debate, with global growth still fairly tepid (despite gathering hopes for a globally synchronised recovery), inflation below target and global indebtedness higher than ever.

“The increase in debt in particular means the world may prove more sensitive to even minor shifts in interest rates, so it may not take a 250 basis point cumulative increase in the US to stoke wider market volatility, as that succession of rate hikes from 3% to 5.5% did back in 1994.”