2023-05-23 04:08:21 ET
Summary
- I have been reducing my exposure to interest rate risks over recent weeks as sticky CPI and a US equity breakout suggest rate cuts are unlikely.
- The iShares Treasury Floating Rate Bond ETF offers investors a way to benefit from high-interest rates while reducing the risk of a reversal in rate cut expectations.
- The TFLO yields 5.4%, which is significantly higher than other Treasury ETFs due to the steep yield curve inversion.
While I continue to prefer fixed income securities to stocks at current yields and valuations, I have been reducing my exposure to interest rate risks over recent weeks as sticky CPI and a US equity breakout suggests the Fed is likely to maintain its focus on fighting inflation for the time being. The iShares Treasury Floating Rate Bond ETF ( TFLO ) offers investors a way to benefit from high interest rates while also eliminating the risk posed by a reversal of rate cut expectations. The TFLO yields 5.4%, which compares with 12-month inflation expectations of 2.0%, which is one of the highest real yields on record.
The TFLO ETF
The iShares Treasury Floating Rate Bond ETF seeks to track the investment results of an index composed of U.S. Treasury floating rate bonds, whose interest payments adjust to reflect changes in interest rates. Floating rate assets have coupon payments that periodically reset based off a short-term interest rate, known as the "reference rate." In the case of the TFLO the reference rates are 3-month T-Bills. The fund has an expense fee of 0.15%.
Steep Curve Inversion Gives TFLO A Huge Yield Advantage
The most attractive thing about the TFLO ETF is the fact that it pays a highly attractive yield of 5.4%. This is fully 3.4pp higher than short-term inflation expectations. According to the difference in yields between regular bonds and inflation-linked bonds, bond investors are expecting inflation to average just 2.0% over the next 12 months. This 3.4% positive real yield is 9pp above the yield that occurred at the lows in March last year.
3-Month UST Yield Vs 1-Year Breakeven Inflation Expectations (Bloomberg)
Widespread expectations for a continued cooling in inflation, as well as the instability seen in the regional banking system, have seen the bond yield curve invert drastically. The spread of 3-month yields over 2-year yields is now a staggering 96bps. According to Fed funds futures markets, investors are anticipating at least one 25bps cut by the end of 2023, and a further six 25bps cuts in 2024.
Fed Unlikely To Cut While Stocks Are Trending Higher
However, elevated trailing CPI and the recovery in stock prices suggest such aggressive cuts are unlikely. Inflation remains elevated at 5.5%, having failed to fall much from its highs. Even on a six-month basis CPI is still running at 3.4%, despite the sharp drop seen in commodity prices over this period. With 12-month breakeven inflation expectations at just 2.0%, bond market investors appear to be far too complacent about the risk of inflation figures remaining elevated.
Such an aggressive drop in inflation would likely require some kind of risk-off market event. However, US equities appear to be breaking out to the upside, with the Nasdaq leading the gains, suggesting that the Fed may have to continue hiking to prevent the equity bubble reigniting. A good example of this was in the late-1990s/early-200s period, when the Fed was forced to raise the overnight funds rate above 6% to finally break the back of the equity market.
Even if interest rates remain at current levels over the coming months, the TFLO is likely to outperform significantly relative to long-term Treasuries, and even relative to short-term bond funds such as the iShares 1-3 Year Treasury Bond ETF ( SHY ). If 2-year Treasury yields were to rise up to the current yield on 3-month bonds, this 93bps rise in yields would result in around 2% losses for the SHY. If the yield on 10-year yields were to rise up the current yield on 3-month bonds, this would result in around 12% losses for the iShares 7-10 Year Treasury Bond ETF ( IEF ).
For further details see:
TFLO: Sticky CPI And Equity Rally Suggest Rate Cuts Unlikely Anytime Soon