There is a saying, at least amongst economists, that the cure for high prices is high prices. In a market that is allowed to function at least somewhat freely, higher prices will generally lead to more supply and less demand.

For example, let’s say that the price of bananas goes up significantly.  As a result, some people who marginally like bananas cut back on their consumption.  And since the price is higher, it serves as a signal to suppliers to grow and sell more bananas.  As people cut back consumption and more bananas are sold in the marketplace, the price should go down (with the typical economic caveat of “all other things remaining the same”).

Oil is also a good example.  If the price of oil goes up, then many people will reduce their consumption (such as driving less). It also becomes more profitable for suppliers to enter the market or increase supplies.  This serves to drive prices back down.

This does not always hold true because there are other variables.  In other words, all other things do not remain the same. If the price of bananas went up because of an overall general increase in consumer prices, then it may not be profitable for suppliers to produce more bananas.  If it becomes more expensive to extract oil from the ground, it may not be profitable to drill for more oil, even with higher prices.

Still, the general rule that higher prices is a cure for higher prices is useful.  We can also apply it to interest rates, which is essentially a price on money.  When interest rates go up, it can become more attractive for investors to buy bonds.  Without any other considerations, a bond that pays 3% interest is more attractive than a bond that pays 1% interest.

There are some major differences though between bonds and bananas.  Beside the obvious that you can’t eat a bond (or at least I don’t know of anyone having done so), I see the major difference being that interest rates are far more significant.  Virtually every transaction involves money, and virtually every loan involves interest rates.  The bond market is humongous and impacts just about every other market there is.

10-Year Yield Spikes, Stocks Crash

Interest rates move in the opposite direction of the bonds.  If interest rates go up, the price of the bonds go down.  So far in the month of October, the 10-year yield has spiked higher.  As I write this, it is above 3.2%.

I write this on the evening of October 10, 2018.  Stocks were clobbered today.  The Dow went down over 830 points.  The Nasdaq went down 315 points, which is over 4%.  Many think this is a reaction to the higher long-term yields.

The yield curve had been flattening, which indicates a possible recession.  In October, the long-term rates have been rising faster than the short-term rates.  In other words, the yield curve has slightly steepened.  Yet, it was this steepening, with higher long-term rates, that is supposedly spooking investors.

The 10-year yield finished essentially flat for the day.  I don’t expect this to continue if the down stock market turns into a bear market.

I am not saying that this is the beginning of a bear market in stocks.  I really have no idea.  We were faked out earlier in the year with some major down days. What I am saying is that when the bear market in stocks does come – and it will come – then the long-term interest rates are likely to fall back down.

I know that libertarians see the disaster of the bloated federal government and the ever-growing national debt.  It is almost hard to believe that the government could be running trillion dollar deficits during supposedly booming times, yet interest rates are still relatively low by historical standards.

But here we are, and the fact remains that most investors view U.S. government bonds as a safe haven investment.  As long as price inflation is seen as contained, then bonds will continue to be a refuge for those seeking safety.

That is why, if we hit a major downturn in stocks, investors are going to seek safety in long-term bonds.  If the bond investors are as smart as they are made out to be, then bond prices should start going up before stock prices collapse, or they should at least rise simultaneously with falling stocks.  In other words, long-term interest rates should fall with a falling stock market.

I don’t put too much weight into one day.  Stock investors likely see this as a one-day selloff from an overheated market.  Most are not predicting an imminent bear market.  The people who think a bear market is coming and coming soon are mostly out of stocks already, at least to a large degree.

If we see more down days where the board stock market is falling 3 to 4 percent or more, I fully expect the 10-year yield (and higher) to start moving down again.

The cure for high long-term yields is high long-term yields.  We may be seeing that this week.  Once the 10-year yield spiked up in just a few trading days, stock investors started to get nervous of the prospect of significantly higher rates.  This likely contributed to the selloff we saw.  But if stocks keep selling off, then this should move rates back down.

It may all seem confusing, and it is to a certain extent.  Regardless of what should happen, we are dealing with the decisions of millions of people (buyers and sellers).

I think there are bubbles in both stocks and bonds.  But I think the stock bubble will collapse first.  The bond bubble has slightly deflated in the last couple of years, but I expect it to be blown back up again when stocks go down and investors seek safety.

We aren’t going to see a full-blown collapse of the bond bubble until we see significantly higher consumer price inflation.  Otherwise, the Fed will just print more digital money to prop it up if the Fed members don’t have to worry about high price inflation.  The Fed will allow rates to rise, but not too far if there are few worries about price inflation.  I don’t think investors, at least for the time being, are going to let rates rise too far either.