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In a (probably apocryphal) meeting between Patton and MacArthur on a battlefield during World War I, Patton flinched when a shell exploded nearby and MacArthur told him not to worry since "it's the one you don't see that gets you." This advice goes a long way toward explaining why shell-shocked investors cling to their bonds, even if not to their guns and religion.

A sound reason to own bonds at any time is that recessions tend to depress equity values and increase the value of high credit quality bonds.

The following table from Fidelity's Market Analysis, Research & Education, illustrates the first part of this simple formula:

Conversely, while the withdrawal of an $85 billion a month customer from the bond market would depress bond prices in the near term, a return to negative GDP growth would overwhelm that effect.

Both the current full valuation in equities and the sell off in bonds earlier this year express a belief that near term recession is unlikely. A shift in that belief would cause both markets to reverse quickly. Recession, eventually, is inevitable; the relevant question is "when?"

Without exception, every recession in the US since the establishment of the Federal Reserve has been preceded by tight monetary policy. Not every period of tight money has led to recession, but no recession has occurred without a Fed tightening. For an excellent academic survey of this relationship see this paper Michael D. Bordo and John Landon-Lane published in February 2010.

The following graph published by the St. Louis Fed provides a clear depiction of the relationship between the Federal Funds Rate and recessions.

(click to enlarge)

Note that from 1955 to 1980 higher Fed Funds rates were required to induce recession. However, since 1980 lower and lower increases have triggered recession. The likely reason for this phenomenon is the increase in leverage over this period. Greater leverage magnifies the impact of interest rate increases.

Since leverage has not fallen significantly since the last recession, the Fed likely knows it has little room to tighten without causing another recession. The markets know the Fed knows this. Asset inflation fueled by additional leverage--arguably, an intended consequence of Fed policy--seems as inevitable in the near term as recession is over some term.

While operating on that thesis, it seems reasonably to be watching for the "one you don't hear."

one candidate is tighter monetary policy in other countries. In a more global economy, so the reasoning goes, tight monetary policy by several other countries could cause recession even though Fed policy is accommodative. So maybe we should worry about China and India flirting with tighter money, but with Europe still accommodative this does not seem to be a very real threat in the near term.

A more immediate threat may be greater regulatory limitations on bank capital and liquidity, which is occurring globally. European authorities seem to be taking steps to increase capital cushions at European banks, which remain significantly less well-capitalized than their American peers. In coordination with other monetary authorities, the Federal Reserve recently announced an initiative to impose a "liquidity coverage ratio" on US banks. In an October 24 article in the New York Times, Chairman Bernanke is quoted as saying "The proposed rule would, for the first time in the United States, put in place a quantitative liquidity requirement..[and]...would foster a more resilient and safer financial system in conjunction with other reforms."

Well-intentioned policy initiatives such as these, designed to help prevent the next banking crisis are reminiscent of the cause of the 1937 downturn which crushed equities almost as badly as the crash of 1929. The paper by Bardo and Landon-Lane referenced above provides an interesting description of the Fed policies which caused this recession.

The 1937-38 recession, which cut short the rapid recovery from the Great Contraction of 1929-33, was the third worst recession in the twentieth century: real GNP declined by 10% and unemployment which had declined considerably after 1933 increased to 20%. The recession was primarily a consequence of a serious policy mistake by the Federal Reserve. Mounting concern by the Fed over the inflationary consequences of the build up in excess reserves in member banks (held as a precaution against a repeat of the banking panics of the early 1930s), led the Board to double reserve requirements in three steps between August 1936 and May 1937. Fed officials were concerned that these reserves would lead to an explosion of lending and would foster a reoccurrence of the asset price speculation of the 1920s. They also believed that reducing excess reserves would encourage member banks to borrow at the discount window. The Burgess-Riefler doctrine which prevailed at the time argued that the Fed could exert monetary control by using open market operations to affect member bank borrowing and hence to alter bank lending (Meltzer 2003).

The consequence of doubling reserve requirements in three steps from August 1936 to April 1937 was that banks sold off their earning assets and cut their lending to restore their desired cushion of precautionary reserves. The Fed's contractionary policy action was complemented by the Treasury's decision in late 1936 to sterilize gold inflows in order to reduce excess reserves. These policy actions led to a spike in short-term interest rates and a severe decline in money supply.

High grade bonds are supported by the recognition that they provide the best protection from the next recession. Any sign of tighter money--intended or unintended--is likely to bring equity valuations lower and lift bond prices.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Bonds Or Equities: Intended And Unintended Consequences Of Fed Policies