The Bond Crash of 2018

Another month of higher interest rates continues the upward trend since my call back in June that interest rates are moving higher.  A slow slog, yes, but bond prices are slowly sinking. The market continues to chip away at the general consensus of  “lower rates longer”.

This is the story of how a gargantuan bond market turns.

Over the course of the thirty-plus year bond bull market no discussion of bonds could be had without mention of inflation. As inflation heated up throughout the 1970s and peaked in 1980, bond prices collapsed…until they collapsed their last. Inflation figures began to decline as well. As double-digit inflation figures became a thing of the past, the bond bull market began to gallop.

Bonds and inflation are believed to be inexorably linked. When asked whether there is risk of even higher interest rates today, most investment professionals will answer no adding that inflation is benign. Ask them why rates are up dramatically in the past few months and  again, most would probably say that there has been a slight uptick in inflation.

As inflation goes, so goes interest rates. Or is it, as interest rates go, so goes inflation. One way or another, the general assumption is that interest rates and inflation are correlated.

Yet the thirty year bond bull market did not move in a straight line. Crashes, large and small, happened along the way. Remember these years: 1987, 1994, 1999 and 2008. These were significant years in bond market investing as interest rates spiked and bond prices tumbled. Funny, I don’t remember inflation spiking in those years.

My definition of a crash is when bond prices move violently lower, usually causing a market shutdown (no bids or no activity).  A preponderance of liquidity suddenly becomes an absence of liquidity.  Bond prices and interest rates which hardly seem to move much at all, suddenly drop many, many points in a day and over several weeks.  Another tell-tale feature of a crash is that almost no one sees it coming.  While not a precise definition, I think we will be able to say we will know it when we see and experience it.  But for all the crashes we have experienced since 1987, the next crash will be our first in a downward trending market; something unprecedented.

Nothing moves in a straight line, certainly not inflation or bond prices or interest rates. Inflation may have ticked up in each of those crash years as inflation just as it has recently. But did the uptick cause the crash, or vice versa? The question is not only moot; the question is irrelevant.

Markets crash because that is what markets do. Lower inflation over the past thirty years may serve as a wonderful explanation as to why bond prices (and stock prices) rose for the past thirty years. But the correlation ignores the crashes, which as memory serves me, have been rather material for both stocks and bonds.

Trend changes occur, though not as often as crashes. Take a look at the years again: 1987, 1994, 1999 and 2008. Add 2018. The year just might fit the pattern. We will have another crash; they happen. But the next crash in bonds will also be the first to occur after the trend change. This adds significance to the coming 2018 bond market crash.

When the 2008 bond market crash occurred I did not know whether it was the end of the bond bull market or not. But we were not taking any chances either, selling long-term bonds into the bond market highs of 2006 and 2007. The crash was significant, but the rebound soon convinced me the bull market was intact. I later called the end of the bond bull market in 2012.

Do I watch inflation? Yes. Did, inflation tell me the bull market was over in 2012? No. The market told me the bull market was over in 2012 and the bond bear market has been slowly gathering steam ever since.

Watching inflation tells me nothing about bonds but everything about inflation. There isn’t any. This fact is problematic for those who believe their livelihood depends upon watching it and commenting on it: central bankers and bond market professionals. The stated position of this crowd is that benign (low, nonexistent, whatever) inflation means interest rates will remain low (“lower rates longer”). Believe that and you might as well believe 2008 is the last crash….ever.

How many crashes have central bankers prevented? I do not know; one can’t prove that. But I do know they did not prevent the crashes of 1987, 1994, 1999 and 2008. I am more than confident to say they won’t prevent the next one. Their behavior these past ten years shows me all I need to know about the abilities of central bankers. With trillions of dollars at their disposal, central bankers have failed to move the needle on inflation at all. Their abilities with respect to the bond market will become apparent once again in the 2018 bond market crash.

So where are we today on the crash road map. Very early still. Some corporate bond and municipal bonds remain near their highs in price, lows in yields. It is the rates on US Treasury two and ten year notes I have been watching. These were the yields that moved prior to the 2008 crash and I believe their moving higher lately foretells the crash of 2018.

The Bond Crash of 2018 does not cause us to change our approach. As interest rates rise, our targets for what we look for in bonds has risen as well.  I continue to not trust municipal bond issuers any further than I can throw them yet we continue to find worthwhile municipals to weather such a storm. My approach has been that such a storm was always in the cards following the 2012 end of the bond bull market. I believe 2018 may be the time we experience the first crash of the bond bear market.