Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Looking at 2014 through the prism of 1994

Unless the United States shoots itself in the foot during the fiscal negotiations, it could conceivably be on the cusp of a recovery. There is a serious possibility that the unemployment rate starts falling towards 7%, and the US Fed begins to consider unwinding some of its unconventional monetary easing measures. Unconventional monetary policy is equivalent to a highly negative policy rate, and so a substantial monetary tightening can happen well before the Fed starts raising the Fed Funds rate.

The situation is reminiscent of 1994 when the US Fed tightened monetary policy as the economy recovered from the recession of the early 1990s. This monetary tightening is best known for the upheaval that it caused in the US bond markets, but the turbulence in US Treasuries lasted only a few months. The more lasting impact was on emerging markets as higher US yields dampened capital flows to emerging economies:

  • The tightening phase lasted from early 1994 to early 1995 during which the Fed Funds rate was increased from 3% to 6%. In today’s situation the equivalent would be a unwinding of the Quantitative Easing (QE) programme beginning early 2014 possibly leading up to a nominal increase in the Fed Funds rate in late 2014 or early 2015.
  • In 1994, 10-year US Treasury yields rose from around 6% to about 8% in less than a year, but during the later stages of the tightening, long term rates actually fell even as the policy rates were being raised. By late 1995, the 10-year yield had fallen back to 6%. The bond market upheaval was frightening to a levered investor in long term bonds, but immaterial for the buy and hold investor.
  • The US stock market shrugged off the tightening completely. Moreover, in the late stages of the tightening, as people realized that the tightening was nearing its end, the US stock market took off. The S&P 500 rose by over a third during 1995.
  • Even as US stocks were soaring, emerging market equities were hammered. The MSCI Emerging Markets Index lost about a third of its value in late 1994 and early 1995. In India, the Sensex fell from a peak of over 4,500 in late 1994 to below 3,000 in late 1996. The Sensex regained its 1994 peak only in the dot com boom of 1999.
  • The Indian rupee also suffered during the period. After years of holding rock steady at 31.37 to the US dollar (with the RBI intervening only to prevent its appreciation), the rupee started falling in late 1995. This fall intensified in the late 1990s.
  • The US tightening claimed its first emerging market victim in the Mexican peso crisis of late 1994 and early 1995.
  • It is conceivable that the US tightening of 1994 set in motion forces that ultimately brought about the Asian Crisis of 1997.

History never repeats itself (though as Mark Twain remarked, it sometimes rhymes). Yet, there is reason to fear that a normalization of interest rates in the US in the coming year could be destabilizing to many emerging markets which are today bathed in the tide of liquidity unleashed by the US Fed and other global central banks. India, in particular, has become overly addicted to foreign capital flows to cover its large current account deficit, and any retrenchment of these flows in response to better opportunities in the US could be quite painful.


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