U.S. Treasury Bonds are the Most Important Market in the World Right Now

By Justice Clark Litle

The most important market to watch right now might be 30-year U.S. Treasury Bonds, known as “long bonds.”

Treasury bonds are supposed to rise in value when the stock market falls sharply. There isn’t a rule that requires this. Instead, it is just the normal way things work:

  • When stocks drop heavily and across the board, capital flows out of stocks and into “safe havens.”
  • One of the largest and deepest “safe haven” destinations in the world is U.S. Treasury bonds and notes.
  • As capital flows into safe-haven bonds, a declining stock market is offset by a rising bond market. 

Again, that is the way it normally works. This relationship is no small thing because trillions of dollars depend on it.

There is a popular money management strategy known as “Risk Parity.” The details are complicated, but the concept is basic. To use a Risk Parity strategy, you generally put a lot of extra weight on the “safe” bond side of the portfolio.

In essence, the Risk Parity strategy is like a traditional 60-40 stock-and-bond portfolio, but with a smaller exposure to equities and a larger exposure to bonds.

There are hundreds of billions of dollars in assets running Risk Parity strategies, and trillions more worth of retirement assets in classic 60-40 style stock-and-bond portfolios.

The problem is that all of these portfolios depend on that normal relationship, where bond prices rise when stocks fall. When stocks are going up, which happens most of the time, the stock side of the portfolio provides growth. But when stocks are going down, the bond side of the portfolio is supposed to provide safety.

That is why Treasury bonds are extra important to watch right now. In recent days, we have seen stock prices and bond prices falling at the same time.

This is bad news for trillions of dollars’ worth of Risk Parity portfolios and traditional stock-and-bond portfolios. It is also an indication that investors are going straight to cash.

When money managers everywhere are seeing investor redemptions en masse — where investors pull their money out in great chunks — those money managers have to sell whatever is in the portfolio to raise cash so they can wire the cash back to investors.

This, in turn, causes the price of all assets to fall, even Treasury bonds. And as we explained, when stock prices and Treasury bond prices fall at the same time, it is a big problem for trillions of dollars’ worth of portfolios.

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At the time of this writing, investors are gripped with fear. With the market action of March 16 breaking records dating back to 1929, it looked like that might be the worst. Now, though, we are seeing it might not be.

Treasury bonds are important to watch because they are a kind of systemic crisis bellwether. If the price of Treasury bonds continues to fall in tandem with stocks, it serves as an indicator the fear is getting worse. There is also the danger of panic selling becoming a self-fulfilling prophecy, in which selling begets further selling in a vicious feedback loop.  

There is also another reason to watch Treasury bonds: When bond prices fall, interest rates rise. As the value of the 30-year bond declines, long-term interest rates rise.

If Treasury bonds fall far enough and fast enough, it will show up as a spike in long-term interest rates, which is the last thing a vulnerable economy needs right now.

That is why, if the Treasury bond price continues to fall sharply, the Federal Reserve may ultimately have to run an even bigger “rescue mission” than anything they have ever done before, committing trillions of dollars if need be to purchase bonds directly.

If, say, $700 billion is not enough, they may have to double that amount, or triple it or quadruple it — or simply commit to “infinity purchases,” meaning a predetermined signal to buy any amount, and print any amount. Yes, they can really do that — and the way things are going, they might.

The coronavirus pandemic did not begin as a financial crisis. But it is putting so much stress on the financial system, we now have a full-blown financial crisis, too. That is what Treasury bond behavior is telling us as of this writing.

The bottom line is that Treasury bond prices can’t keep falling the way they are at the time of this writing. They just can’t.

If this goes on too long, it could bring about what was feared in 2008 — the financial system equivalent of a massive heart attack. 

In conditions like these virtually everything gets sold, regardless of valuation or outlook. The entire market becomes a kind of liquidity black hole.

And yet, again, conditions like these are also temporary by definition. They can’t be permanent because stress levels this extreme, if they last for too long a time, would tear the financial system apart.

When financial conditions ease again — not back to normal, but at least notching closer to normalcy — we could see various areas of the market take off like a rocket. Not all industries and sectors by any means, but the ones now undervalued by any rational measure.

This would be a counterreaction to the indiscriminate selling we now see, which is all about liquidity and margin calls and forced redemptions (and has little to do with market valuations at all).

Treasury bonds are worth watching on this front too, because an improvement in the bond market could hint at either hyper-aggressive Federal Reserve action beyond anything yet seen, an easing of extreme market stress, a notching back towards normalcy, or a combination all three.

We are in territory now that no investor has experienced in his or her lifetime. You would have to be well over 100 years old to know and remember conditions like these, or anything at all comparable. 

Hang in there. We’ll get through this.