Financial market volatility is always the highest at turning points. And high volatility is what we're experiencing now. Various economic indicators signal that we're nearing the end of the current cycle. The market is now transitioning from an overextended seven-year bull market to a bear market.
This isn't a bad thing for smart investors. There are just as many ways to make money in a bear market as there are in a bull market. One major opportunity is purchasing U.S. Treasury bonds that have 20 or more years left until maturity.
Historically, long-dated U.S. bonds have performed spectacularly during volatile bear markets. In the crash of 2008, the iShares Barclays 20+ Year Treasury Bond made more than 30% while the S&P 500 lost nearly 50%.
There are a few key reasons Treasuries do so well during bear markets.
For one, investors treat U.S. debt as a safe haven when markets get rough. The world flocks to U.S. Treasuries when the global economy runs into trouble. What's safer than returns guaranteed by the most powerful government in the world?
Treasuries also do well during recessions. Many times, these recessions coincide with bear markets. As we explained before, economic indicators are signaling tough times ahead. The team at Foundation Investing sees an increased probability of entering a recession towards the end of the year. Recessions are deflationary. And during times of deflation, expectations for inflation plummet. With lower expected inflation, the real return for bonds increases. This makes them more attractive and causes more investors jump in.
In recessions with low growth and inflation, the Fed will reduce the federal funds rate to try to boost liquidity. The rate cuts not only affect short-term bonds, but also long-term bonds. And when yields fall, bond prices rise. This again makes bonds an attractive investment.
The Federal Reserve is currently trying to convince investors that it plans a series of rate hikes over the next two years. This would usually cause bond prices to fall. But markets are calling the Fed's bluff. They know the Fed can't raise rates with conditions as they are. The price action of iShares Barclays 20+ Year Treasury Bond confirms these investors' sentiment. The ETF recently broke to the upside from a year-long wedge and is now ready to take off.
Take a look at the chart below. Somehow U.S. paper has the highest yield of any sovereign debt in the world. It's insane that Spanish and Italian debt trade at higher premiums than U.S. debt. Both those countries are nearing crises.
This discrepancy shows how much room U.S. debt has to run. It's undervalued. As this mismatch corrects itself, investors will flood into U.S. Treasuries. The iShares Barclays 20+ Year Treasury Bond will make a massive move to the upside as a result.
Another big factor influencing U.S. Treasuries is China. China is the largest foreign holder of U.S. bonds. It has about $1.5 trillion worth of them. But with the global economic slowdown and currency wars, China has been forced to sell off a lot of its holdings to support its own currency, the renminbi. The renminbi purchases are part of Beijing's efforts to devalue its currency in an orderly fashion. But it's becoming tough to fend off the global forces pushing to devalue at a much faster rate. And so, the Chinese may soon give up on trying to manage it. This would relieve them of the need to sell off any more U.S. Treasuries. If this occurs, Chinese selling pressure would be removed and the iShares Barclays 20+ Year Treasury Bond would rocket higher.
This article is commentary by an independent contributor. At the time of publication, the author was long Treasury bond futures.