24 March 2019
Fears of a bubble in the US bond markets have intensified recently, prompting some experts to warn of another crash like the one seen in 1994. Photo: Bloomberg
Fears of a bubble in the US bond markets have intensified recently, prompting some experts to warn of another crash like the one seen in 1994. Photo: Bloomberg

Why we may see a repeat of the 1994 US bond crisis

Recent economic data from the US has been very promising, with the country adding more than 200,000 jobs for three months in a row.

There has been intense speculation in the market about the timing of an expected rate hike by the Federal Reserve.

That said, as there are fears that China’s economic woes could slow down US recovery, will the Fed again delay the “lift-off”?

Looking at the US dollar index and yield movements of US Treasuries, investors do seem to think that a rate hike won’t occur in September.

A correction in US stock markets has stemmed from several factors, including a strong US dollar, interest rate uncertainty and worries about the potential corporate earnings impact from a slower Chinese economy.

The Dow Jones benchmark has generated a negative return of 2.4 percent so far this year, and there has been a capital outflow from equity funds. The redemption wave has also affected exchange-traded funds.

Meanwhile, the Nikkei and Dax indices have posted gains of 18.4 percent and 15.2 percent respectively so far this year. Both markets are far more attractive than US after factoring in the currency issue. Investors could obtain even better return if they hedge the currency risk.

If the Fed decides to hike interest rate, ignoring words of caution from investors like Warren Buffett, will US corporate earnings be able to sustain high growth, at a time when eurozone, Japan and China have persisted with monetary easing and weakened their currencies? 

Beijing has resorted to currency devaluation and monetary easing in a bid to ensure that its economic growth rate does not slip below 7 percent.

The currency moves caused nervousness on global markets, intensifying the correction in equity prices. This offers a good buying opportunity for medium and long-term investors.

The economic situation in the US is quite similar to that in 1994, when the Fed hiked the interest rate from 3 percent to 6 percent.

Bond prices slumped 20 percent after the 1994 rate increase, but US equities reacted calmly.

But now, many investors have resorted to leverage to boost bond investment returns after years of low interest rates and rising bond prices.

Global investors in US bonds have enjoyed a good party for the last eight years, and they are less worried about rate changes. But if the market condition reverses, they could suffer huge losses due to usage of leverage. That could lead to another bond market crisis.

In recent months, investors have fled to US bonds in light of sharp volatility in the Chinese markets and disappointing economic data there. And China has been exporting deflation worldwide through weaker currency. The 10-year US treasury yield has been steadied at 2.153 percent.

The 10-year treasury has become the best choice for institutional investors like pension funds, who are looking for high credit-rating and good return investment amid low inflation and falling commodity prices.

Market demand for US bonds remains robust, given that 10-year Germany bond only has 0.63 percent yield, and 10-year Japan bond yield was only 0.38 percent.

Any sell-off of US bonds and deleveraging effort by investors could lead to another debt crisis, if the Fed kicks off the rate hike.

Meanwhile, Beijing is keen to get back its dominance in foreign exchange policy and get rid of US influence. It has decided to let the renminbi move to a lower level against the US dollar in a bid to help the nation’s exporters.

As the yuan devaluation plays out, the Fed could consider postponing its rate hike.

Ma Jun, chief economist at the Chinese central bank’s research bureau, has said that the yuan devaluation is a one-time fix. However, we believe that the renminbi could weaken further in the short term. It will weigh on several assets, including stocks and bonds.

This article appeared in the Hong Kong Economic Journal on Aug 13.

Translation by Julie Zhu

[Chinese version中文版]

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Founder and Managing Director of Pegasus Fund Managers Ltd.

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