Meet The New Boss, Same As The Old Boss, …Sort Of

Feb 23, 2018

Back in the olden days of the 1970s and 1980s, there was a correlation between bond and stock prices, where stock prices dropped along with bond prices as interest rates increased. Back then, interest rates were much higher, as inflation was the prevailing economic threat. Any rise in interest rates was seen as destructive, increasing borrowing costs for every manner of credit, especially housing.

Inflation and high interest rates were a big problem for the global economy in the 1970s into 1981, but were eventually tamed by a rather draconian Federal Reserve policy under then Chairman Paul Volcker, who in 1981 raised short term interest rates to a towering 18.5%. Interest rates finally peaked in 1982 and never looked back. Dropping interest rates and rising bond prices spurred economic growth and stock price appreciation for years to come, as the positive correlation between bond and stock prices persisted throughout the 1980s.

In the go-go 1990s, disinflationary forces driven by new technology took hold,  increasing efficiencies  in many industrial sectors. Commodities prices dropped as production soared. “Beneficial Disinflation” they called it. Inflationary threats subsided throughout the 1990s. Interest rates then were still quite high by today’s’ standards, but less than half of their 1982 highs. Traders began to rethink the relationship between bond and stock prices, as deflation became the primary threat. In deflation, interest rates plunge, raising high grade bond prices sharply while corporate earnings sag and stock prices drop. Thus, the diametric price relationship between bond and stock prices was established, and became the reflexive reaction to an entire generation of traders and investors until around the end of 2017. That’s when things began to change.

The bull market in bonds, in place since 1982 may now, at last, be at an end. Though smart-aleck pundits and investment commentators (yours truly included)  had long called for an end to the bond bull market and a bottom in interest rates, we were repeatedly proven wrong year after year by a voracious global appetite for bonds of all sorts, as investors kept hedging against deflation, not inflation.

In late 2017 into 2018, interest rates on 10 year T notes began to break out of a long standing trading range where yields rarely exceeded 2.6% and traded as low as 1.37% during the 2016 global growth scare. By late January 2018, the 10 year T Note yield broke through 2.8%, reflecting expectations of an increasing number of Federal Reserve interest rate increases on short term rates. For the first time in ages, “inflation” became a scary word.

Only a few months before, economists, The Federal Reserve and business leaders were all wishing for a long awaited increase in inflation, targeting 2% for the Consumer Price Index, (CPI) a rather antiquated indicator that presumably tracks the cost of living. Once CPI ticked upward just a bit as the US economy got some upward traction and worker’s wages at long last gained some upward momentum, the inverse correlation between bond and stock prices began to unravel.

So now a whole generation of investors and traders who have never seen stocks and bonds go down at the same time are introduced to the new old reality, where there is no place to hide when the inflation threat drives down bond prices, causing a ripple effect of losses that can quickly spread to stocks and other asset classes.

Meet  the new boss, same as the old boss, that is if you’re old enough to remember the old boss.