U.S. Bonds 2004: Déjà vu 1994?
The Federal Reserve left little question it will hike interest rates soon, leading many to question whether a repeat of 1994 can be expected. IO 1994 when the Fed raised the Federal Funds rate by three percentage points within a year’s time, some financial institutions rushed to unwind their positions, putting pressure on rates that subsequently popped, increasing the cost of funding for all issuers. Despite many of the market parallels between these two periods, significant differences remain, making a repeat unlikely. However, there remains the risk that rates could jump as some financial institutions exit their positions.
Both 1994 and 2004 share similarly shaped yield curves. In 1994, short-term rates at 3.0% were 300 basis points lower than the 10-year Treasury rates while similarly in 2004, short-term rates at 1.0% are 350 basis points lower (Chart 1). However, 1994 experienced a rapid increase in the Federal Funds rate to 6.0% in a single year with little advanced warning. In contrast, the Fed in early 2004 began to telegraph its intention to gradually raise interest rates, most recently as “measured increases.” Standard & Poor’s is forecasting short-term rates to reach 1.5% by year- end from the current 1.0%, eventually reaching 4.0% by year-end 2005 (Table 1). This cautious advancement of the Federal Funds rate allows financial institutions to move more adeptly than elephants rushing out of a barn at the same time as they did in 1994. The 100 basis point rise in the 10-year Treasury rate to 4.78% since mid-March this year is evidence of this happening. Moreover, the absolute level of interest rates in 2004 is approximately 200 basis points lower than in 1994. Such a healthy buffer combined with very gradual rate increases implies that supply conditions could remain favorable for all financial and nonfinancial borrowers. In addition, improving credit quality conspires to keep corporate credit spreads tame. This combination of Treasury rates and credit spreads-still low by historical standards-should keep funding costs attractive.
| Low | High | Change in Rates (bps) | ||
|---|---|---|---|---|
| 1994 | 10-Year T | 5.16% (10/15/1993) | 8.03% (11/7/1994) | 287 |
| Fed Funds | 3.00% (2/1/1994) | 6.00% (2/1/1995) | 300 | |
| 2004 | 10-Year T | 3.10% (6/13/2003) | 6.00% (Year-end 2005 forecast) | 290 |
| Fed Funds | 1.00% (5/1/2004) | 4.00% (Year-end 2005 forecast) | 300 |
Unlike the events of 1994, the pressure on U.S. credit quality in 2004 continues to ease as earnings gain momentum on both financial and nonfinancial issuers and may lead to a tightening of bond spreads within a more narrow range. The rush of financial institutions exiting their positions in 1994 both stressed their credit quality and led to higher interest rates. The financial downgrade ratio 1 in 1994 rocketed to 71% by year-end 1994 from 21% the year before. With the Fed expected to take twice the time to raise rates and providing a long period of advanced warning, the same situation is unlikely to repeat itself in 2004. Currently, the downgrade ratio on U.S. financial issuers stands at 63.6% following steady improvement from the downgrade ratio recent high of 85.0% reached in 2002. U.S. investment-grade credit spreads are currently range bound between 85 basis points and 90 basis points versus 73 basis points in 1994 (Chart 2). Looking ahead, further tightening is possible as credit quality continues to improve and economic stability demonstrated. The CBOE OEX Volatility Index (VXO), a good indicator of spread direction, has been in decline since mid2002 coinciding with improving credit quality (Chart 3). As the U.S. downgrade ratio continues to improve, the VXO should follow with diminished volatility and encourage a narrow spread range with moderate tightening possible.
The dividend payout ratio has also been highly correlated with credit spread movement for well over a decade (Chart 4). And while the directional trend has held, the magnitude of the dividend payout ratio decline over the past three years surpassed the decline in U.S. credit spread, indicating the potential for further tightening. Additionally, the dividend payout ratio as of fourth quarter 2003 was 50.2%, nearly 10% below first quarter 1994 with 59.7%.
1 The downgrade ratio is calculated at the number of rating action downgrades divided by the total number of rating actions.