The most inflation-sensitive ETFs
The highly anticipated Federal Open Market Committee meeting last week failed to settle the heated debate over inflation and interest rates.
The Federal Reserve, as expected, has kept its overnight key rate close to zero and has hinted that it may start preparing to cut back its bond buying program in the not-too-distant future. But the central bank has largely maintained its position that the recent spike in inflation will be a transitory phenomenon.
The initial reaction to the Fed’s announcement – a surge in 10- and 30-year Treasury bond yields – quickly reversed the next day. The market just can’t make up its mind on inflation and interest rates.
Yield on 10-year Treasury bonds
The fastest rate of inflation in decades
At the heart of the debate is whether inflation in the United States will continue to far exceed the Fed’s 2% target.
The latest Consumer Price Index (CPI) showed that the prices of goods and services jumped 5% year-on-year in May, the fastest pace of growth since 2008. The less volatile core CPI, which excludes food and energy prices, jumped 3.8% in the month, the fastest rate since 1992.
Core CPI (year-on-year growth)
Whichever metric you look at, inflation is currently much higher than the Fed’s target.
For some investors, this is a problem. They believe that amid a booming economy and rapidly rising prices, the central bank should tighten monetary policy, nipping inflation in the bud.
In their view, the Fed is far too dovish, which will keep inflation high and interest rates much higher from here on out.
Supporters on the other side of the debate – to which the Fed subscribes – argue that high inflation is only transitory, the consequence of a one-time massive economic recovery, a post-pandemic reopening of the economy and base effects (unusually low inflation over the past year).
As for the latter, the core CPI rose only 1.2% year-on-year last May, at the height of containment measures linked to the pandemic. Comparing this year’s prices to the depressed levels of last year, inflation looks higher than it would be under more normal circumstances.
Additionally, the $ 5 billion in fiscal stimulus triggered by COVID-19 – including hundreds of billions of dollars in direct cash payments to taxpayers – is obviously not something that will repeat itself over and over again.
Likewise, the immediate post-pandemic period, when a colossal amount of pent-up demand is released all at once, is a unique thing.
To illustrate this point, the Bureau of Labor Statistics noted that a third of the increase in inflation in May was due to an astonishing 29.7% year-over-year increase in car prices. ‘opportunity. Air fares, another category that was weighed down last year due to the lockdown measures, jumped 24.1% year-on-year last month.
A chart by Matthew Boesler of Bloomberg shows that excluding price spikes in transportation-related categories, inflation is at a much more normal level.
Impact on bonds
All this does not mean that there is no risk of sustained and high inflation. Inflation is always a risk, and if it were to persist at a high level, it would have a significant impact on asset prices, including stocks and bonds.
Nowhere would this risk manifest itself more clearly than in the bond market. Bond investors are hypersensitive to the vagaries of the inflation rate because inflation matters a lot to the “real” (inflation-adjusted) return these investors receive.
Higher-than-expected inflation could trigger a massive sell-off of bonds, especially longer-dated bonds which are more sensitive to changes in interest rates (bond prices and yields move in the opposite direction). The iShares $ Treasury Bond 20 + yr UCITS ETF (IDTL) ETF has fallen 8.4% so far this year, as of June 22, as long-term rates have climbed from their all-time low of 2020.
The iShares $ Treasury Bond 7-10yr UCITS ETF (IBTM), which aligns closely with the all-important 10-year Treasury Bill, has lost 3.4% year-to-date.
If inflation surprises on the upside, these ETFs will likely be affected. Conversely, they could also recover if the long-term disinflationary trend that was evident before the pandemic reaffirms.
Credit spreads and corporate bonds
Corporate bond ETFs like iShares $ Corp Bond UCITS ETF (LQDE) and iShares $ High Yield Corp Bond UCITS ETF (IHYU) face somewhat different dynamics than Treasuries. Interest rates matter to them, of course, but so do credit spreads – or the extra return investors demand to take on credit risk.
As the economy booms and businesses find themselves full of cash, credit spreads have narrowed to historically low levels, offsetting some of the negative pressure from rising rates. The LQDE is down 2.8% year-to-date, but IHYU is up 2.5%.
Earlier this week, Bloomberg reported that junk bond yields, as measured by the Bloomberg Barclays US Corporate High Yield Index, had fallen to a record low of 3.84%.
Growth equity / interest rate link
While bonds are the asset class most directly affected by fluctuations in inflation and interest rates, stocks are by no means immune. For much of this year, growth stock prices have fluctuated with changes in the yield on 10-year Treasury bonds.
Changes in interest rates affect the present value of future earnings and cash flows, and this phenomenon tends to have a disproportionate impact on the stocks of high growth companies that are expected to generate the majority of their profits in the years to come. come.
This link between interest rates and theoretical valuation of stocks is not always apparent in market prices, especially since many factors influence stocks on a daily basis. This year, however, the correlation between rates and growth stocks has been particularly strong.
The ARK Innovation ETF (ARKK) was hit hard between February and May as the 10-year Treasury yield hit its recent high around 1.75%, and it has since rebounded as the 10-year yield fell. returned to about 1.5%.
Yet, as you’ll notice in the chart below, the ARKK and 10-year yield both rallied last year, reinforcing the idea that the interest rate / growth share relationship is not. in no case frozen.
ARKK (blue) vs 10-year Treasury yield (yellow)
Still, most investors would agree that, other things being equal, lower rates are better for all stocks, both from a valuation and debt financing perspective. Any sudden change in the outlook for inflation, and therefore the outlook for interest rates, is bound to have spillover effects on the stock market, at least in the short term.
The debate rages on
With the Fed potentially ready to begin unwinding its massive stimulus packages in the coming months, all eyes will be on the inflation data. The trajectory of consumer prices will have ramifications for how quickly or slowly the central bank tightens its monetary taps, thereby altering interest rates.
The mere hint of the Fed cutting its bond purchases over the next few months was enough to push rates up everywhere this week.
The 30-year Treasury bond yield – which is sensitive to inflation expectations – has fallen to a four-month low below 2.1%, while the two-year Treasury yield – which is more influenced by the Fed’s key rate – jumped to 0.21%, its highest point in a year.
Active management of duration, credit and inflation risks with ETFs
This flattening of the yield curve is a victory for the “inflation is transitory” camp, even if the debate on inflation is far from over.
The inflationists are still here, although it will behoove them to show that after three decades of falling consumer prices, it’s really different this time around.
This story was originally published on ETF.com
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