Summary: Bonds are in a bubble. There is no rational explanation for rates this far below the rate of inflation or for negative yields in Europe.

But when the bubble bursts is an open question. Until then, as bond prices rise, stocks are likely to fall further.

Stocks staged a rather tentative rally yesterday after a 3% decline Wednesday, when the 2-10 year Treasury yield curve briefly inverted, raising fears of a recession within the next two years.

The bond market has staged a huge rally this year with 10 year Treasury yields falling from 3.25% to just over 1.5%. Just this month, yields have fallen almost 40 basis points, a huge decline. When yields go down, bond prices go up. For traders and aggressive investors, that means that bonds have been just about the best large market opportunity over the past couple of months.

In normal times, stocks and bonds compete for investor dollars. That suggests they should stay in a near equilibrium. When bond prices rise (and yields go down), stocks should also rise as lower yields mean higher P/E ratios. Conversely, when bond prices fall (and rates rise), that would normally be a headwind for stocks.

But today isn’t normal. Since the July 31 FOMC meeting and the August 1 tweet from President Trump that tariffs would be increased on Chinese imports beginning on September 1, stocks have fallen by more than 5% and bonds have soared. What is happening is that momentum chasers are selling stocks to buy bonds. Some media sources claim this is a flight to safety. But while 10 and 30 year Treasuries may be safe from a principal standpoint, they move widely with changes in rates. These bonds are not being bought by long term investors trying to lock in 1.5% or 2.0% for 10 or 30 years respectively; they are being bought by traders who are betting that tomorrow someone will pay more for those bonds than they can get today.

The extreme is in Europe, where as much as half of sovereign debt now trades at negative interest rates. In Germany, 10 year Bunds trade at a rate of -0.60% and 30 year bonds trade at a yield of -0.20%. Seriously, would you pay $108 for a bond knowing that you will get $100 back in 10 years with no interest payments in between? I doubt it. But you might pay $108 if you were convinced that the price tomorrow would be $110.

This is what you call a bubble.

Bubble burst. When, we don’t know. It could be tomorrow or it could be a year from now. But there is no rational explanation to tell you why anyone would want to buy a bond at a negative interest rate or even at a rate so low that, adjusted for inflation, you pay nothing or even less.

In the short run, stocks will continue to drop until bond prices stop going up in a straight line. When might it end? In 2012 and again in 2016, the 10-year Treasury briefly traded between 1.3% and 1.4%. Inflation then was running under 2% and the long-term outlook was for inflation of about 2%, exactly the same as today. If you poll investors today, you will hardly find anyone who would suggest that the 10-year Treasury could trade at 3% or higher. Yet that is exactly where it was at the start of this year, just 8 short months ago.

When everyone is on the same side of the trade (in this case betting on lower rates), it won’t take long for that to be a losing trade. At some point, rational behavior will take over. But I can’t tell you when. Disruptive tweets don’t help. In the meantime, the path of least resistance for bonds is up and for stocks is down. However, when that turns, it could push rates back up as fast as they came down. Parabolic tops and bottoms are often V-shaped.

Yes, I know world growth is slowing and that may seem to be an ingredient for lower rates. But look at the data and not the headlines. June retail sales rose by 0.7%, a huge number. Weekly unemployment claims show few layoffs. The CPI this week was up 2.2% annualized. Mortgage refinancing applications surged. There are no signs of inflation in the current data.

As long term investors, we just have to wait this out. Emotional insanity doesn’t last all that long. At some point, and I mean within weeks, bonds will stop rising and stocks will regain footing.

If there is a negative for stocks, it’s valuation. Despite recent losses, stocks are merely approaching the midpoint of fair value. Since the start of 2018, stocks have traded between 2450 and 3000 on the S&P in round numbers. We are still a bit above the mean. Profits have been flat since the start of 2017 ex-the impact of Trump’s corporate tax cuts. I expect they will remain fairly flat over the next year, meaning stocks may well stay within the range for an extended period. A sharper than expected rate cut from the Fed or a tariff truce with China could ignite a big rally but without either, the short term likelihood is for stocks to drift lower until real bargains appear.

Today, Steve Carell is 57. Madonna turns 61.

James M. Meyer, CFA 610-260-2220

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