Federal Reserve Chairman Alan Greenspan was called before the Senate Banking Committee last week to explain the recent series of interest rate hikes by the central bank.
In his testimony, Mr. Greenspan noted that the low short-term interest rates of the past few years pushed many people into mutual funds, and explained why rising rates prompted some investors to rethink their choices. Excerpts follow:
Lured by consistently high returns in capital markets, people exhibited increasing willingness to take on market risk by extending the maturity of their investments.
In retrospect, it is evident that all sorts of investors made this change in strategy -- from the very sophisticated to the much less experienced.
Reaching for Yields
One especially notable feature of the shift was the large and accelerating pace of flows into stock and bond mutual funds in recent years.
In 1993 alone, $281 billion moved into these funds, representing the lion's share of net investment in the U.S. bond and stock markets.
A significant portion of the investments in longer-term mutual funds undoubtedly was diverted from deposits, money market funds, and other short-term, lower-yielding, but less speculative investments.
And some of those buying the funds perhaps did not fully appreciate the exposure of their new investments to the usual fluctuations in bond and stock prices. To the degree maturity extension was built on a false sense of security and certainty, it posed a risk to financial markets once that sense began to dissipate.
Federal Reserve moves initiated in February, along with a number of other developments in the U.S. and other major industrial economies in the same period, were instrumental in radically altering perceptions of where interest rates were going and of the risk of holding longer-term assets...
. . . As volatility and uncertainty increased, people began to reverse their previous maturity extensions.