Etiology of a Bond Massacre

Whodunnit?

Tooze did a piece on the 1994 bond market massacre that I’ve been mulling ever since. The essay included these fascinating quote from Yardani who is credited with coining the (in)famous phrase “bond vigilantes”:

Bond Investors Are The Economy’s Bond Vigilantes. So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.

If the government enacts policies that seem likely to reignite inflation, the vigilantes can step in to restore law and order to the markets and the economy.

Ed Yardani, quoted in Tooze, “The Strange Case of the 1994 Bond Market Massacre.”

This picture of the economy and public finance being supervised by bond investors is a staple of the neoliberal imaginary. The famous remark by James Carville, also quoted by Tooze, attests to the power of this idea:

I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.

James Carville

It is true that global bond markets exercise a robust disciplinary force; particularly on hard-pressed third world sovereigns. This has to do with the fact that these sovereigns usually face hard-currency constraints. So when they run into trouble, it usually takes the form of a currency crisis. Even the smaller hard currency-issuing central banks find it difficult to win a tug-of-war against global investors. Recall how George Soros forced the Bank of England to capitulate in 1992. Or take the more recent case of the Swiss central bank which faced what Gourinchas and Rey called “the curse of the regional safe asset provider.”

But does this disciplinary logic apply to the world’s largest supplier of safe assets? not to mention, the closest thing we have to a global military hegemon? Whether or not the military balance can any longer be described as unipolar, what is not in doubt is that the military balance was most definitely unipolar in the 1990s. The United States also enjoyed unprecedented economic preeminence, accounting for no less 25 percent of global output. Total federal debt stood at a relatively modest 64 percent in 1994. Inflation was running at a moderate 3 percent. Under these extremely benign conditions, how is it that the Clinton administration felt so intimidated by the bond market? And what exactly happened in 1994?

The basic facts are clear from looking at the performance of Treasuries. Here we focus on the period presided over by Greenspan and proxy the return to bondholders by the returns on the 10 year zero-coupon bond. By this benchmark, bond investors marked a loss of 15 percent on their portfolios in 1994.

A graph of cumulative returns during the year shows the rapidly and depth of the decline. This looks like a stock market rather than a bond market! The losses piled up in Feb and March, stabilized somewhat during the summer, before crashing again in the Fall. What the hell happened?

Tooze cites Thorbecke, who argues that there are two explanations. As Tooze puts it:

One is that the markets took Greenspan’s decision to raise rate as a signal that the Fed had inside information about future inflation risks to which the market was not privy. If the Fed was raising rates then it was time to sell bonds. The alternative explanation is that the Fed’s intervention raised uncertainty about the future course of policy and this raised the premium that investors required to justify holding bonds of any kind.

Adam Tooze, summarizing the argument in Thorbecke and references cited therein. Emphasis mine.

The two explanations amount to very different etiologies of the bond market massacre. The first suggests that higher expected inflation got priced into bond markets because bond investors inferred that Greenspan knew that things were worse than they looked on the inflation front. That would amount to a real constraint on the first Democratic president since Carter. The second suggests that the price of interest rate risk went up as bond investors became more uncertain about the path of Greenspan’s policy rate. That would be a policy error by Greenspan.

A third possibility, not mentioned by Thorbecke or Tooze, is that bond markets priced in a considerably steeper path of the policy rate, which mechanically led to massive losses on bonds held in investor portfolios. If the steep expected path of rates was necessary, this would just be the price of macroeconomic stabilization. If it was unnecessary, it was again Greenspan’s error.

In what follows, I will try to convince you that it was indeed a policy error. The 1994 bond market massacre was caused by Greenspan’s fuck-up.

There are two legs to this argument. First, that Greenspan spent his time at the Fed fighting tight labor markets. This was a systematic error that introduced a powerful deflationary bias into the world economy, as I have argued previously. Second, that the bond market massacre is mechanically explained by the mark-to-market losses directly due to the rise in the discount/policy rate.

I document Greenspan’s response function by looking at how he responded to changes in the consumer price index and unemployment rate. The graph on the left shows changes in the consumer price index against changes in the policy rate; the graph on the right shows changes in the unemployment rate against changes in the policy rate; both at the quarterly frequency during his tenure. You can see that the Greenspan Fed raised rates when unemployment fell, while the relationship with inflation, while it bears the correct sign, is considerably weaker, suggesting that he was always hiking in anticipation of inflation based on labor market tightness.

The second leg is also easily documented. In the next set of graphs, the top panel is the policy rate; the middle panel is the CPI; and the bottom panel is unemployment; all for 1987-1994. When Greenspan began the hiking cycle in January 1994, consumer price inflation had been moderate for years; and indeed falling for a year. But as the bottom panel shows, unemployment was also falling, mistakenly leading Greenspan to believe that inflation would revive. That’s why he began raising rates at a ridiculously rapid rate: he raised the policy rate from 3 to 5.5 percent during the course of 1994 — no less than 10 quarter-point hikes in a single year!

What was the response of poor investors whose bond portfolios began to sink like a stone? Greenspan’s hikes and the implied steeper expected path of interest rates got priced in rapidly. By the summer, the yield curve had shifted up out to 30 years. But as Greenspan kept hiking like a central banker possessed, the yield curve flattened out. The bond market simply refused to buy that this absurdity could go on for much longer.

As it happens, the bond investors were right. Greenspan’s hiking cycle was soon reversed. He was forced to cut the policy rate down to 5 percent in 1995, where it stayed for the next two years. There is simply no evidence to suggest that Greenspan had any privileged information about inflation. Even if he believed he did, he was wrong about it.

Far from being the dominant disciplinary force in the global economy, bond investors were at the receiving end of a catastrophic policy error by the so-called maestro. It’s possible that Clinton insiders bought the bond vigilante narrative. It’s also possible that they used it to justify their “turn to the center.” In either case, there were no bond vigilantes intimidating anyone in 1994. If anything, they were bleeding through the nose from the blows they got from the madman at the Fed.