On October 6, 1979, the Board of Governors of the Federal Reserve System led by Paul Volcker announced a slew of anti recessionary measures, the most significant measure being, that the Federal reserve would target the quantity of money rather than the price of money, more specifically the amount of bank reserves in the system. The price of money can be measured by the Federal Funds Rate. Hence, the Federal Reserve would stop trying to maintain a high degree of stability in the federal funds rate and instead set a target of how much of bank reserves they would like in the system. These measures were in the backdrop of high rates of inflation prevailing in the American economy, in the year 1979, the consumer price index rose by 11.3 percentage points.
Targeting bank reserves ultimately meant targeting a particular level of money supply and this would result in a high degree of volatility in the Federal Funds Rate. As a result of these measures, bond trading became highly profitable for wall street. Bonds which have been generally considered as a “safe” asset suddenly became the money maker for all trading firms.
Before we go into the details, unlike today, the federal funds rate was not announced at the end of every meeting. Instead, people had to infer the funds rate from the open market operations which were announced at the end of every meeting.
The Federal Funds Rate and how it affects the market rate of interest
The Federal Funds Rate is the rate at which depository institutions can lend their excess reserves held with the Federal Reserve to other depository institutions. Hence, the Federal Funds Rate acts as a benchmark for the market rate of interest.
How things worked till October 1979
The federal funds rate is considered as the price of money, while, M1 is the most commonly considered measure of the quantity of money in the system.
Until 1979, a target rate for the federal funds rate was set by the Federal Reserve, hence, the federal funds rate was pretty much fixed, thus, money supply was the only variable to clear a market disequilibrium. To ensure a stable federal funds rate, the federal reserve would have to increase the supply of money if there was an excess demand for money (if the supply of money was not increased then the actual federal funds rate would rise above the target rate). On the other hand, if there was an excess supply of money in the system, the federal reserve would need to reduce the quantity of money (again, if the supply of money was not decreased then the federal funds rate would fall below the target rate).
This increase or decrease in the supply of money and hence bank reserves by the central bank is done through open market operations. Open market operations is basically buying and selling of government securities by the central bank. To increase the supply of money (and hence bank reserves), the central bank would buy government securities, and, to reduce money supply (and hence bank reserves) the central bank would sell government securities.
Thus, interest rates were primarily fixed to a certain range and would vary only marginally. This marginal variation provided bond traders with little room to make profits, hence, bond trading departments were probably the most “boring” departments till the meeting of October 1979.
Post October 1979
Post the meeting of the board of governors in October 1979, the Federal Reserve started targeting the quantity bank reserves in the system rather than the price of money, hence, the above way of functioning ceased to exist.
Now, the only variable to clear a market disequilibrium was interest rates since money supply (through bank reserves) was fixed by the federal reserve. Hence, when the demand for money (and hence bank reserves) rose in the market, the only way for markets to clear was for the actual federal funds rate to increase. On the other hand, if there was excess supply of money (due to excess bank reserves) in the system, the actual federal funds rate would fall to clear the markets.
Hence, the federal reserve would decide on a target level of of bank reserves, conduct open market operations to achieve the given level and once achieved, the federal reserve would withdraw from the market.
This left interest rate as the only variable to clear markets, hence, interest rates were quite volatile between the years 1979 and 1982 (when the federal reserve returned to targeting the price of money), rising to a peak of 19% in late 1980 and early 1981.
This volatility provided bond traders with a golden opportunity to make money.
Interest Rates and Bond Prices
Bonds are fixed income securities i.e. a security which pays the holder a fixed rate of return or interest in the case of a bond.
The basic principle of bond prices is that as interest rates rise, bond prices fall. On the other hand, as interest rates fall, bond prices rise.
For example, if a bond worth $100 is issued at 6%, it means that every year the bond holder would get $6 as return on investment.
Now, over the life cycle of the bond, the market rate of interest may vary quite a bit, for example over the 25-year period ended 2015, the lending rate has hit a high of 10% and a low of 3.25% in the United States. Thus, over a life cycle of a bond, the market rate may vary to a great extent.
Taking our above example, the value of the $100 may vary to a great extent over a 25-year period, the $100 bond would have been valued as high as $184 when the market rate of interest was 3.25% while it would have been valued as low as $60 when the market rate of interest was 10%. While this a huge simplification of how the bond market works, it captures the essence of how bond prices are determined over its life cycle.
October 1979 and its impact on the bond market
While bond prices varied a great deal over its life cycle, bond prices fluctuated only marginally in the short term (short term would mean less than one year) due to the Federal Reserve policy of “high degree of stability in the Federal Funds Rate in the short term” prior to 1979, bond trading was not a very exciting profession for traders as prices varied only marginally on a daily basis.
Post the October 1979, lending rates started fluctuating to a great extent on a daily or even hourly basis, this meant bond prices also fluctuated to a great extent on a daily or hourly basis.
As can be seen in the above figure which shows the Federal Funds Rate on a monthly basis, between October 1979 and October 1982, the federal funds rate fluctuated to a great extent every month. Before and after the period between October 1979 and October 1982, volatility in the federal funds is almost non existent.
Thus, a huge opportunity for bond trading was created by this policy of targeting the quantity of money. A $100 bond issued at 15% in March 1980 would be valued at $158 in June 1980 and at $78 in January of 1981.
In the year 1980, 30year Treasuries yielding 9.25% (issued in 1979) swung from a high of 96.688 in June to a low of 71.188 in December, this is a 36% range within which bond prices swung. Such a wide gap is uncommon for any year be it prior to 1980 or post 1980. The daily average of government securities traded in 1980 was $18.1 billion, which was 37% higher than the previous year.
Bond trading thus became the most profitable department in most trading firms, Salomon Brothers was one such example. Equity trading which was previously the most profitable department in most firms got relegated to the sidelines since bond trading profits dwarfed the profits of equity trading.
The overall aim of the policy was to reduce inflation, which it was successful in doing, by the end of 1982 inflation below 5% and the policy of targeting money supply was brought to an end.
The years 1979 till 1982 were one of the most exciting periods for bond traders and the bond markets as a whole. This boom in bond markets led to new innovations and trading techniques by bond traders and investment banks. Junk bonds and CDO’s (Collateralized Debt Obligations) were two of the most prominent innovations of this period.
Thus, the October 1979 meeting was probably one of the most important days for bond markets, if not for that meeting, who knows, we may not have seen giants like Salomon Brothers or innovations like junk bonds and CDO’s.