I recently had a conversation with a colleague about the idea that portfolios over the last 40 years have been conditioned for falling interest rates. If that supertanker makes a turn, a lot of money will be on a collision course. He said in 1984 there was an equal and opposite issue … buying bonds for the prior 20 years had been a fool’s errand. The cycle climaxed in June 1984 with a hot GDP, a low inflation print and a collapse in bonds. Even though inflation was low, no one wanted to own them.

I was intrigued and pressed the conversation with our resident bond historian and partner, Paul DeRosa. His response below:

It was the bond buying opportunity of the 20th century. The long period of inflation and the large deficits run by the Reagan administration conditioned people to believe inflation was only temporarily low and that it would return, as it had in 1980. I bought 250 million of the 13 ¾ of May 2014 and was down 10 million on the trade before I wrote the buy ticket. With the funds rate at something like 11.5%, the yield curve actually got steeper rather than flatter. The current situation is something like the inverse of that period. We’ve had a long period of low inflation, and a lot of people still think it is temporary. So, I would expect rates to rise grudgingly and the yield curve to stay flat. The good thing about finance is that illusion eventually has to face reality. By late summer of 1984, the high interest rates had the economy on its proverbial tail. Payroll employment started to sag. I remember buying a boatload of the Treasury 4-yr Note in September, but it still was very hard to get people to accept lower yields. To keep from worrying about it I played squash at the New York AC, but checked the market between games.

Just to finish this up, 1985 was a pretty good year for the bond market, but the big break came in Spring of 1986, when the crude oil price collapsed. It took a big external event to change expectations about inflation. I completely missed that move because I misread the situation. The stock market also rallied, and I couldn’t figure out how bonds could rally with the stock market so strong. Well, the answer, of course, was the stock market was rallying because it saw rates falling.