Echoes of 1994 bond meltdown stoke market’s Fed fear

Corporations, governments and individuals have feasted on debt since the Fed took its benchmark rate to near zero in late-2008 as the financial crisis raged. Total nonfinancial debt has jumped from $35.1 trillion in 2008 to a record $47.5 trillion as of the first quarter, an increase of nearly 35 percent, according to Fed data.

“There’s no free lunch to have rates at zero for as long as they did and quintupling of of their balance sheet,” Boockvar said. “Reversing that is not without a mess.”

The 1994 lesson is fraught with peril — hedge fund collapses, corporate debt scandals, and a lasting warning sign about raising rates at the wrong time. Boockvar believes the Fed waited too long to hike in this cycle and now faces danger.

Fed rhetoric, though, has shifted to more dovish tones lately. Chair Janet Yellen during recent congressional testimony said the Fed may not have much further to go until it reaches the level where its policy is neither accommodative nor restrictive. That would coincide with a “real” funds rate, or the actual level compared to inflation, around zero.

“They need to avoid shocking markets, catching markets off guard. They’re always worried about an accident in the market that then causes collateral damage,” said Quincy Krosby, chief market strategist at Prudential Financial “There’s a difference between an accident and a mistake. A mistake is something more systemic.”

“If you remember 1994, when rates rise something always breaks,” she added.

Of course, the Fed’s calculus doesn’t just involve rates. There’s also the matter of what to do with the $4.5 trillion the Fed finds on its balance sheet in the form of bonds it purchased to help stimulate the economy out of its crisis doldrums. All but about $800 billion of that came in three rounds of purchases known as quantitative easing.

That’s another reason why Krosby expects Yellen and her fellow officials on the Federal Open Market Committee to be cautious about tightening. Prior to Yellen’s congressional appearance, markets were worried the Fed had changed from data dependence to a preset course.

“The Fed work with Wall Street, and certainly on a major undertaking like this, they’re not going to do this in a vacuum,” Krosby said.

The FOMC has a two-day meeting this week starting Tuesday. No one thinks the Fed will raise rates at this meeting, but there is speculation that it could signal the beginning of the balance sheet unwinding for September. The committee will allow designated caps of the proceeds it gets from maturing bonds to roll off and will continue to reinvest the rest.

Krishna Guha, an economist at Evercore ISI, said the FOMC will “avoid making any big calls on rates for several meetings” particularly as long as inflation stays low.

Traders are currently pricing in a 48 percent chance that the Fed hikes again before the end of the year, according to the CME.

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