The stock market, or all financial markets, has changed significantly over the past couple of decades. The main way they have changed is that the concept of individualism is gone, where assets behave separately and individually from each other. Today, all markets are interconnected in ways that investors need to pay attention to if they want a chance at success.
That means if asset classes like gold or currencies start to make a move, and their correlations swing from a positive to negative or vice versa, investors need to be aware of what’s causing this relationship so that they can play it accordingly and profit from the swing.
For that reason, today’s shifting market to benefit from a potential long trade in bonds is essential.
More specifically, there are three main reasons that investors should look into the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT) for the coming months and quarters, especially as price action in other inflation and interest rate-sensitive asset classes shows them how the future might look brighter for bond prices.
With this in mind, here’s the first reason investors can consider this bond exchange-traded fund (ETF) for their portfolio.
Inflation Slowdowns Call For Adjustments in Bonds
The way iShares 20+ Year Treasury Bond ETF has been selling down for the past couple of months is not completely connected to the current business environment. While some asset classes and stocks, like consumer discretionary names, have behaved in a way that might signal inflation, fears of rising prices and costs are just not there today.
The recent gauges of inflation that the Federal Reserve (the Fed) considers, like the PCE and PPI indexes, are the opposite of what these stocks call for. This is why the price of gold has just gone on a major pullback, along with other inflation-sensitive assets like crude oil and their respective pullbacks.
Why would inflation-driven commodities be coming off their highs if inflation is the driver behind the bond sell-off? As that doesn’t make much sense, that would build the foundation for the three reasons behind the bullish thesis behind a potential long in this bond ETF.
An adjustment in bond prices to the actual inflation situation would allow investors to take advantage of this ETF's risk-to-reward setup. The downside (meaning higher rates) is minimal compared to how high prices can go (and subsequently lower rates).
Small Cap Stocks Converge With Bonds, Divergence Next?
The correlations between small-cap stocks, as seen through the iShares Russell 2000 ETF (NYSEARCA: IWM) and iShares 20+ Year Treasury Bond ETF, have risen to a cyclical high. That means their price action is now converged, as the two asset classes have essentially declined over the past few weeks.
What follows naturally from this convergence is a correlation breakdown expressing itself as a divergence between small-cap stocks and bond prices. Fundamentally, as covered in the previous point, a bond rally is much more likely than a sell-off, making this divergence a likely setup that will benefit bonds the most.
It also makes fundamental sense, as small-cap stocks (made up of smaller domestic businesses) can’t diversify away costs or cycles as effectively as large-cap stocks can. Slowing inflation and business activity will likely keep small caps lower while bonds rally, consequently lowering yields.
Then, as correlations come back down to cycle lows and yields are down to reflect inflation easing and Fed cuts, the environment would be much friendlier to let small-cap stocks rally back and converge to the upside with bonds.
Energy Stocks Expected to Boom, Bullish for Bonds?
Warren Buffett took the lead in the energy sector when he recently bought up to 29% of Occidental Petroleum Co. (NYSE: OXY), as he knows what the bond bottoming could bring next. As inflation business slowdowns affect small caps, they also affect oil demand and prices.
However, once these rate cuts trickle down to the rest of the economy, bond rallies and lower yields could not only help small-caps but also boost overall business activity in the broader market. That is when oil demand could come back on the scene, boosting the price per barrel and related stocks.
Correlations between bonds and the Energy Select Sector SPDR Fund (NYSEARCA: XLE) show this theme at play. A convergence makes little sense, as these assets are typically negatively correlated. A natural divergence from here would favor a bond rally before an oil rally comes in, giving investors a third way to justify a buy in the ETF.
