Finding the right rhyme

Market bloodletting may be more 2003 than 1994

The bloodletting in financial markets may be more 2003 than 1994. Bankers are smart to ask if the recent jump in rates could cause a replay of bond pain two decades ago. But 2003 may be a better comparison. Markets threw a hissy fit when the Fed signaled easy money would end. But it didn't last long. More importantly, nothing big blew up.

The missing body count may be why many don't remember 2003. But the similarities between now and then are hard to ignore. The Federal Reserve had been on a mission to get the economy back on track. It had cut short-term rates and Ben Bernanke, a mere Fed governor, had put bond buying on the table as a means to bolster the economy, if needed. But in June, the Fed cut rates by a smaller than expected amount, signaling that money wasn't likely to get much easier.

Then, like now, investors had a tantrum. The benchmark 10-year Treasury yield jumped more than 100 basis points in six weeks, credit spreads widened and overseas markets quaked.

Investors pulled more than $10 billion out of US bond mutual funds in just five weeks, according to Lipper. That equated to 1.4 per cent of fund assets, more than the 0.9 per cent of outflows over the three weeks ending June 19 this year. But investors soon adjusted and markets settled down. The 10-year yield even eventually fell.

Back to 2013, rates may still rise further, including short-term rates which have been at or near zero in Japan and the United States for some time. And, the magnitude and duration of the developed world's extraordinary monetary policy, which has helped add $10 trillion to central bank balance sheets in the past six years, according to the Bank for International Settlements, has distorted asset prices. These may swing too far the other way before finding more normal levels. By putting an expiration date on quantitative easing, Bernanke has essentially hit the reset button on the global financial system. It may yet get worse. But the events of 2003 should at least give some hope that markets can adjust without calamitous losses.