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US Treasuries Through a History of Crisis - Ramy Saadeh

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U.S. Treasuries through a History of Crisis:-OPEC oil price shock (1973)-Second oil price shock (1980)-Black Monday (1987)-First Gulf Crisis (1990-1991)-Mexican Crisis “Tequila Hangover” (1994)-Asian financial crisis (1997)-Russian financial crisis (1998)-Dot-Com Bubble (2001)-Sub-prime mortgage crisis (2008)-European sovereign debt crisis (2010)Appendix (Global Charts)

Text of US Treasuries Through a History of Crisis - Ramy Saadeh

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    Banque Bemo sal

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    Acting Director - Treasury & Capital Markets : Mr. Joseph Mikhael

    Analyst: Ramy Saadeh



    MAY 2014

    U.S. Treasuries through a

    History of Crisis

    OPEC oil price shock (1973) Second oil price shock (1980) Black Monday (1987) First Gulf Crisis (1990-1991) Mexican Crisis Tequila Hangover (1994) Asian financial crisis (1997) Russian financial crisis (1998) Dot-Com Bubble (2001) Subprime mortgage crisis (2008) European sovereign debt crisis (2010) Appendix (Global Charts)

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    U.S. Treasuries through History

    After the new millennium, the economic impact of oil shocks became, to a certain extent, less destructive growth, thus reflect-ing a milder impact on the financial markets. However, previous responses had a decisive effect on overall inflationary develop-ments and consequently on monetary policy and treasury rates.

    OPEC Oil price shock (1973) The economic measures adopted by the United States in 1971 triggered inadvertent implications on the western economies, known as the Nixon Shock. These measures, to a certain extent, bear the culpability of the Oil Shock which drove the industrialized nations into stagflation; a recession depicted as a Malaise. Subsequent to the unilat-eral exit of the United States from the Bretton Woods Ac-cord, thus abolishing the gold exchange standard and float-ing the US Dollar, developed countries tremendously ex-panded their currency reserves as they transitioned to free floating fiat currencies. This resulted in a depreciation of most currencies, including the US Dollar, thus reducing the value of real income, namely for OPEC countries (as oil is priced in US Dollar) which resented the state of affairs and had a penchant to substantially increase oil prices.

    However, the situation was exacerbated after the Yom Kip-pur War and the ensuing Operation Nickel Grass which brought the members of the Organization of Arab Petroleum Exporting Countries (OAPEC) to proclaim an oil embargo on the 18th of October 1973. The latter drove oil prices to quad-ruple to 12 Dollars/Barrel. This surge in oil prices induced an inflationary environment coupled with a recession.

    Prior to the embargo, the 1968 Vietnam War hindered the US economy as unemployment dropped, while taxes, interest rates and raw material costs rose. Treasury yields have been progressively rising due to inflationary concerns breaking the 8% level in the mid 1970. However, as the US money supply was increasing, West Germany left the Bretton Woods system in May 1971 while other countries redeemed their dollars for gold. Throughout this period, Treasury yields rose from 5.38% since March 1971 to 6.95% in July the same year. Since the 15th of August 1971, the end of US dollar/gold convertibility, treasury yields retraced their way to 5.73%. However, the depreciation of most currencies and the decrease in the value of real income drove inflation higher; Treasury yields grew in tandem reaching 7.55% in August 1973. After the accord be-tween Saudi King Faisal and Egyptian president Anwar Sadat in Riyadh to use the "oil weapon" as part of the upcoming military conflict, investors sheltered in the treasuries, pushing yields to a low 6.67%. But as the inflationary repercussions of the oil embargo appeared to linger, the treasury market (and Equity market) sold off and yields reached 8.15% around the end of August 1974. Even after the end of the embargo, bond yield continued to rise topping 8.60% in 1975.


    Crude Oil Vs Benchmark yield (1971-1975)

    Source: Bloomberg, Bemo Research

    Federal Funds target Rate Vs Benchmark yield (1971-1975)

    Source: Bloomberg, Bemo Research

    S&P500 Vs Benchmark yield (1971-1975)

    Source: Bloomberg, Bemo Research

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    U.S. Treasuries through History

    Second Oil price shock Iran-Iraq War (1980) From 1974 to 1978, the world crude oil price was relatively flat ranging from USD 12.52/ barrel to USD 14.57/barrel. However, demonstrations against the Shah of Iran commenced in October 1977, setting path towards a drastic change in the situation which materialized with the out-break of the anti-shah movement in 1978 and the seizure of the power by the Islamic republic in February 1979. On the 4th of November 1979, hundreds of Iranian students who supported the conservative Muslim cleric Ayatollah Khomeini stormed the U.S. Embassy in Tehran, taking more than 60 American hostages, driving the US President Jimmy Carter to retort with a complete embargo of Iranian oil. De-spite limited global supply shortage due to the Iranian crisis (a mere 5%), the ensuing panic drove prices significantly higher. Furthermore, on the 16th December 1979, two OPEC member states announced plans to raise the price of their oil to the highest they had ever been as a diplomatic maneuver to sustain prices. These incidents precipitated the second oil crisis that burst with the Iran-Iraq War. Since the first oil crisis, OPEC supply remained relatively flat around 30 million barrels/day. As the war loomed, oil sup-ply was curtailed by 6.5 Million barrels, representing 10% from the previous years global supply driving oil prices to USD 39.50/barrel in 1981 as inflation peaked at 14% during the cataclysm.

    The 1980 oil crisis had adversely impacted the Treasury market. Between 1975 and 1977, inflation in the US had been slightly subdued, dropping off 12% to settle below 6%; US treasuries fluctuated in parallel. But as the political unease emerged, treasury yields edge up from a sub 8% level to break above 9% by the end of 1978 and then reaching 11% by the end of 1979 driven by the swirl of events and quarrel. However, the sharp increase in yields, which reached 16% in 1981, was provoked by the amplifications of the ultimate Iraq and Iran collision. After the 1980, reduced demand from OPEC and overproduction, namely due to the expansion of non-OPEC, resulted in a glut on the world market; this ushered half a decade decrease in oil prices which bottomed at USD 14.44 in 1986.

    During both oil shocks, the policy response was to assume the shock to be momentary and carry on a loose monetary policy, thrusting inflationary expectations in an inflationary setting. It was until the appointment of Paul Volker and ag-gressive money supply targets, allowing the federal funds rate to approach 20%, that the Inflation began to appease in 1981. By the end of 1983, the inflation rate had de-creased to less than 5% and during 1985 to 3% while treas-ury yields fell substantially from around 16% in 1981 to north of 6% in 1986.


    Crude Oil Vs Benchmark yield (1976-1985)

    Source: Bloomberg, Bemo Research

    Federal Funds target Rate Vs Benchmark yield (1976-1985)

    Source: Bloomberg, Bemo Research

    S&P500 Vs Benchmark yield (1976-1985)

    Source: Bloomberg, Bemo Research

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    U.S. Treasuries through History

    Black Monday (1987) The anti-inflationary policies implemented during the 1980s curtailed the inflation until 1986; however, at the outset of 1987, inflation appeared to accelerate moder-ately, particularly in the light of the rapid growth of money supply. During this phase, strong demand for US dollars - driven by the US financial Markets, the safe haven of US bank deposits for LATAM countries, the worldwide drug trade brought the US dollar to appreciate against foreign currencies. However, this trend was reversed early 1985 as markets perceived the Fed to drive down the value of dollar deliberately by expanding money supply to cover the US trade gap; this catalyzed a massive drop in the dollar value. As a consequence, under the terms of the Louvre Accord, the central banks of six industrialized countries decided to limit further depreciation of the dollar and stabilize its ex-change rates within narrow band, thus suppressing mone-tary inflation. Subsequently, the Fed sold USD 8.4 Billion of government securities in one month (4% of its entire stock) in an effort to limit the expansion of money supply. This resulted in a collapse of the treasury market, yields in-creased to 8.45%, up from 7.21% in one month, compelling the Fed to alter its stance towards an expansionary one which in turn drove the dollar to depreciate once again de-spite strong coordinated intervention. Concerns of a dollar free fall and monetary inflation drove the Federal Reserve to tighten monetary policy by hiking the Federal Funds Tar-get Rate by 50 basis points in April and another 25 basis points in May 1987 to counteract exchange rate pressure. These hikes prompted instability in both the bond and cur-rency markets; treasury yields reached 8.86% after the sec-ond hike before stabilizing around 8.27% by the end of June. However, the trigger for the sell-off was Alan Greenspans - the newly appointed Fed Chairman - abrupt decision to fur-ther raise the discount rate by 50 basis points. Interest rates continued their ascent until the 14th of October 1987 when different events (Iran Silkworm M

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