The 1994 Bond Market Rout

Why this matters

Most market crashes are about stocks. 1994 was about bonds, including US Treasuries, which carry essentially no risk of default. Ten-year Treasuries lost 8% that year, one of their five worst years since 1928,¹ and the Bank for International Settlements estimated worldwide bond losses at about $1.5 trillion, almost 10% of the combined GDP of the OECD countries.² It's the textbook case of interest-rate risk, and it changed how the Federal Reserve talks to markets.

The setup

The Fed had cut its federal funds target to 3% in September 1992 and left it there.³ With a slow recovery from the 1990 to 1991 recession, low inflation, and efforts to cut the federal budget deficit, long-term yields were relatively low as well.² The 10-year Treasury yield touched 5.19% in October 1993.⁴

Markets also had little to go on about what the Fed would do next. At the time, the Fed issued no statement after its meetings, didn't announce changes in its target, and released the minutes of each meeting only after the following one.⁵

The surprise

On February 4, 1994, the Fed raised its target by a quarter point, to 3.25%, its first increase since 1989. Members worried that after so long the move could have a large announcement effect, and for the first time, the Chairman issued a brief statement announcing the change.⁵ Alan Greenspan announced it immediately, the statement said, "so as to avoid any misunderstanding of the Committee's purposes."⁶

It wasn't the first increase that hurt. Just before it, prices in the futures market implied about 1.1 percentage points of increases over the coming year. The Fed delivered 3.⁵

Federal Reserve Board.³

Why long-term yields rose so far

Long-term yields rose by more than the Fed's own increases. Inflation expectations began to climb, and some analysts predicted the federal funds rate could go as high as 8%. Long-term rates didn't begin to fall until the Fed raised its target by three-quarters of a point in November.²

Treasury yields are daily, with the highs on November 7, 1994; the mortgage rate is Freddie Mac's weekly survey average.⁷⁸ A homebuyer locking a 30-year mortgage at the end of 1994 paid about 2 percentage points more than a year earlier.

Bond paying 6% a year	Price at a 6% yield	Price at an 8% yield	Change
Matures in 2 years	$1,000	$964	−3.6%
Matures in 10 years	$1,000	$864	−13.6%
Matures in 30 years	$1,000	$774	−22.6%

Prices calculated with semiannual payments. A new bond now pays 8%, so an old 6% bond has to sell at a discount big enough to give a buyer the same yield. The longer the bond, the more years of below-market payments its price has to make up for, so the bigger the fall. Duration and Convexity turns this into a single number.

The rest of this lesson is for members

Still to come in this lesson: Leverage: Orange County, The soft landing, What changed: talking to markets, the key takeaways, and 2 quiz questions with explanations.

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