Last summer I noticed that the possible bond bear market was three years old. Now we might be four years into it!
Not saying that it's going to happen, but it's going to upset a lot of people's plans if SPX starts falling and bond yields start rising.
People are used to an overall falling interest rate trend (since Sept 1981!), which has been a tailwind for asset values, but they are also used to a shorter term inverse correlation where people flee equities for the safety of bonds.
That's the principle that 60/40 asset allocation is based on - if you own stocks and bonds, at least one will always be "working".
But remember Charles Dow Looks at the Long Wave: that pattern that asset allocation is based on has existed because we've been in the long period in between the peak in interest rates and the peak in stock prices, as Charles Kirkpatrick explained:
"The period after interest rates peak is when stock prices rise as an alternative investment. During that period declining interest rates force yield-conscious investors into alternative investments of lesser quality in order to maintain yield. Since stocks are the most risky and least quality investments, they become the final alternative, especially when their price continues to appreciate as a result of increasing cash flow into the stock market. [positive feedback loop] The recent conversion of government-guaranteed CD deposits into stock mutual funds is typical during this period. Unfortunately, it eventually leads to the declining long wave in stock prices."There could be a period when stocks and bonds go down together. For example, instead of stock declines -> people wanting the security of bonds, people might decide that stock declines lead to bailouts which are really stealth currency devaluations, and decide they want no part of the long end of the yield curve.
Remember, all of the federal, state, and municipal governments are planning to borrow to cover their operational and pension shortfalls. They think it will be no big deal thanks to low interest rates. In the most recent Fortune, Trump essentially says that he would grow the national debt - he's a developer and he loves low interest rates!
I've said that the federal public debt was only $6 trillion when Bush left office, and there's easy ballpark math that says that within a decade, the public sector will need to borrow that much every year.
The other scary thing for bonds is the effect that interest rate increases have on this system, because it contains so many feedback loops. The pension assets become worth a lot less, the interest expenditures rise (and they are borrowing to pay the interest since there is no debt service), so the credit quality (such as it is) deteriorates.
Also, corporate pensions have the same problem and an interesting feedback loop of their own. To the extent that their pension funds lose money, earnings will take a hit. As we know from Grantham, when earnings fall multiples fall too.
It is very, very nonlinear, because once bonds lose momentum, who will want to own them? Professional asset management and retail investor sentiment are both all about momentum. And every credit - government or corporate - looks much worse with rising interest expense. I think we will come to realize that a lot of stuff in the economy (junk bonds, private equity) was part of a virtuous interest rate cycle.
For the counterargument that the Fed will just buy bonds to "keep rates low", you have to face the fact that QE invariably caused rates to rise, and you could (and we did) make money buying bonds every time the Fed stopped buying them. As I kept trying to explain, the QE bond purchases may have been respectably large in relation to the flow of debt issuance, but they were puny in relation to the stock of $60T of dollar denominated debt. It freaked creditors out about inflation more than it helped.
The legitimate purpose of public debt is to borrow money to build infrastructure improvements that have a positive net present value. However, a vast portion of federal expenditure now leaves nothing tangible, leaves no collateral. A treasury bond is a certificate that money has successfully been expended on section 8 housing, or on make-work military "jobs".
The lack of collateral makes these treasuries creatures of social mood. They are no more valuable than tulip bulbs or south sea shares. That makes them vulnerable to going down with stocks when social mood becomes more pessimistic.
If you synthesize the best parts of Falkenstein and Redleaf, you predict that the next crisis is going to come in the investment that is currently perceived as riskless enough for highly leveraged institutions like banks to buy. Right now, government bonds are accorded zero risk in calculating bank capital ratios. The idea that government bonds are riskless when governments are planning to flood the market and when the expenditures are consumed (building no collateral) may prove to be the latest extraordinary popular delusion.
Krugman has spent years poking at the "invisible" bond bear. The problem is that years of success at borrowing for consumption (not investment) without any noticeable effect on interest rates made the Keynesians in government complacent and cocky.
P.S. For Buffett fans: he didn't become a billionaire until 1986, five years after rates peaked. 99% of his net worth was made during the declining interest rate trend.