Summary
- Floating Rate Notes now offer 5% or more in yield.
- Increased inflation from global economic activity, especially from China, is pressuring rates higher.
- Equity valuations are unattractive compared to risk-free rates.
- A picture is worth a thousand words, but a chart is worth a thousand pictures.
U.S. Treasury Floating Rate Notes ((FRN)) have been the top holding in my portfolio since last June. The thesis behind the move was that short term interest rates would continue to rise higher and pressure on equities would lead to price declines. I became bearish on bonds and stocks in March 2022 when the Fed's tightening cycle started in earnest. During this span, the Federal Funds Rate has risen from 0% to 4.75%.
This has benefited FRNs because the notes pay interest based on a spread rate set at issuance, currently 0.2%, and a floating rate equal to the latest 3-month Treasury Bill discount rate. You can see in the chart below how the rate on 3-month bills has trended steadily higher over 2022. The iShares Treasury Floating Rate Bond ETF ( TFLO ) is an ETF that invests in FRNs and the dividend of this ETF has trended higher with 3-month notes. The trailing dividend yield, as pictured below, is 2.38%. This is because the 3-month bill rate has averaged about 2.3% over the last 12 months. But going forward, TFLO has a 30 day SEC yield of 4.68% and yield to maturity of 5.01%.
By its nature, FRNs should meet or beat 3-month bills as long as rates do not decline. With the yield curve deeply inverted, 3M bills and FRNs offer higher rates than 10 and 30 year bonds. 6M and 12M bills and the 2Y Treasury offer slightly higher rates because the market expects rates to be higher during those timeframes.
The investment thesis for FRNs depends on the direction of interest rates and the attractiveness of alternative investments. At present, the data suggests that rates will remain higher for longer. Additionally, I find equities to be particularly risky. These are the reasons I remain invested in TFLO.
Inflation Has Not Been Defeated
The bond market has been discounting Fed forecasts for months now. The yield curve inversions indicate that the market does not believe what the Fed is saying and are expecting cuts to interest rates over the next 12-24 months. As of January, the forward curve was well below the FOMC dot plot which indicated that no rate cuts were expected in 2023 with a terminal rate of about 5.25%. But over the past few weeks, new data and FOMC member comments have led to a major repricing. The CME FedWatch tool data shows that market participants expect a 90%+ probability of Fed Funds rate at 5.25% or higher by September. This means a 50-100 basis point increase in rates is most expected.
The Daily Shot (used with permission)
One of the reasons for this shift in thinking is that inflation data is heating up again. The ISM manufacturing prices paid index ticked up sharply in February. This data is leading PPI and CPI higher.
The Daily Shot (used with permission)
In addition, the labor market is remaining resilient. Weakness in employment is necessary for the Fed to stave off wage inflation. It also means that the Fed has flexibility to continue tightening until material weakness is experienced.
The Daily Shot (used with permission)
One reason for this uptick in inflation is that global economic activity is picking up. The global SMI showed a distinct increase in growth in February and the largest increase in sales growth in a year:
The Daily Shot (used with permission)
This activity is mostly the result of China ending its pandemic lock-downs. The China manufacturing PMI launched higher in 2023 and the trend is likely to continue for several months or quarters:
The Daily Shot (used with permission)
What this means is that the Fed is going to be under pressure to continue moving rates higher. Currently, the Fed Funds rate is poised to overtake core PCE, a preferred inflation measure of the Fed, with the next rate hike. However, as history shows the Fed has a tendency to keep the FFR above core PCE for a few quarters until economic weakness and a satisfactory control of inflation warrants rate cuts. This suggests that rate cuts are not likely in 2023.
Equities Are At Risk
The 4.5-5% yield on FRNs may not seem attractive compared to returns of equity markets, but the risk-adjusted return is superior in my opinion. Equities are not priced for these higher risk-free rates. For one, the S&P 500 ( SPY ) earnings yield is a pitiful 0.3% higher than the 3M bill. This is the lowest since 2002 when the Dotcom bubble was deflating and earnings were falling.
The Daily Shot (used with permission)
Speculation is rampant that equities have bottomed here due to their recent performance compared to a plethora of analogs. One that is often cited is the equity performance in relation to Fed tightening cycles. It is well understood that equities perform after a pause in rate hiking. While this is a plausible outcome, whenever that pause may occur, I find it disconcerting that the S&P 500 has broken the lower boundary of average S&P 500 performance following Fed tightening cycles. It means that there's something unique going on during this cycle, and unique is not good.
The Daily Shot (used with permission)
To compound the issue of the earnings yield premium to risk-free rate, equity earnings are expected to decline in the year ahead. Leading indicators suggest that the decline could range from 5-10%. While equities always bottom before earnings bottom, it is very uncommon for equities to bottom before the end of the tightening cycle.
The Daily Shot (used with permission)
Summary
Floating rate notes offer the most attractive risk-adjusted returns among bonds and equities in my opinion. This is because rates are expected to go higher due to increased global economic activity and an uptick in inflation data. Until rates begin to decline, FRNs will be a relatively safe place to park cash. The TFLO ETF provides investors with access to FRNs through their brokerage account. The fund's convexity is 0.00 which means that there is virtually no sensitivity to rates on the bond value. When the rate pause is in view it will be time to reassess the attractiveness of FRNs, but until then it remains my largest position.
For further details see:
TFLO: Why It's My Largest Position