iShares 0-3 Month Treasury Bond ETF: Safety in Inflation Limbo

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Alicat

Market participants were disappointed to learn that the September CPI came in at 8.2% YoY, above expectations of 8.1%, and the March CPI fell exceeded expectations by 0.2% to 0.4%. Additionally, Core CPI registered 6.6% YoY and 0.6% MO, illustrating that Core CPI continues to rise sharply against of rising interest rates.

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Data by YCharts

Persistent, or sticky, inflation presents a challenge for investors and the Federal Reserve. As some categories of goods and services drop in price, including gasoline and cars, other categories become more problematic, including rent and housing costs.

The result is something of a dead end for inflation data. The Fed is trying to act efficiently and with determination. Yet progress is slow to materialize. Investors face tough decisions in this state of inflationary vacuum. Going short in the market ahead of a Fed pivot will prove disastrous. Committing to additional rate hikes and liquidity risk for a long time is equally dangerous. That’s why I look for the security and the respectable 3-4% yield offered by treasury bills through the iShares 0-3 Month Treasury Bond ETF (NYSEARCA:SGOV).

The limbo of inflation

The Fed’s favorite inflation measure, the core PCE, is showing some stubbornness as lagging inflation data prolong high inflation levels. For August, MoM PCE was 0.3% and MoM Core PCE was 0.6%, beating expectations.

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Data by YCharts

Over the past two decades, the 10-year Treasury rate has rarely been lower than the Core PCE rate until 2021, when the Core PCE soared. The Federal Reserve was slow to raise rates, causing rates to rise quickly to catch up with the PCE. Currently, the 10-year Treasury is still 1.76% below the Core PCE, suggesting that rates are more on the upside.

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Data by YCharts

Below is a chart from The Daily Shot that breaks down the CPI data by component. Notice how the base CPI rate has outpaced the headline CPI over the past three months. Weakness in energy, mainly gasoline, kept the inflation rate below 0.5% MoM. But the services CPI leads the index higher with key contributions from housing rent.

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The Daily Shot (used with permission)

I’ve written before about how housing cost inflation is particularly lagging behind. Here is what I said:

The first reason why it will be difficult for the Fed to meet this target is that housing is slow to change and the evolution of housing inflation is lagging. The rent calculation method in the CPI lags market rent changes by 6-9 months. Market rent lags house price changes by 12 to 18 months. The chart below shows how the recent increase in the Case Shiller House Price Index has driven the 12-month CPI and CPI Rent. House prices have only recently begun to peak and fall. Since June, home prices have fallen 2%, the fastest pace since 2009.

Data from Redfin shows that rental price growth is slowing significantly. Asking rents were only 9% higher year-on-year in September, compared to 18% year-on-year earlier this year. That’s the good news. The bad news is that it will take months for an improvement in the housing rent component of the CPI to show.

Further data from The Daily Shot below shows that many economic indicators support that inflation should already have slowed by this point. It is clear from the data below that inflation is approaching a tipping point. However, the stiffness of Core CPI and PCE inflation prolongs the pain.

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The Daily Shot (used with permission)

Look for safety in treasury bills

I expect more volatility in the stock and bond markets if interest rates continue to rise. These inflation numbers put more pressure for that to happen. In recent comments, Federal Reserve Bank of Philadelphia President Patrick Harker said:

We will continue to raise rates for some time to come…given our frankly disappointing lack of progress in reducing inflation, I expect we will be well above 4% in here the end of the year.

Markets followed suit. Futures markets are pricing a >50% chance that the fed funds rate will be above 4.5% by the end of the year. Monetary tightening leads to economic weakness. Data from all of the Fed’s regional surveys for unfilled orders and shipments have slumped this year and predict a significant decline in gross margins. This is an example of widespread economic data that predicts lower growth in the future.

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The Daily Shot (used with permission)

To protect my portfolio from this uncertainty and volatility, I continue to maintain a large position in US Treasuries. The Treasury bill rate has risen above 4% and offers a substantial return for risk.

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Data by YCharts

I use the iShares 0-3 Month Treasury Bond ETF to invest in treasury bills. The fund invests in 0-3 month Treasury bills and pays the proceeds in the form of monthly dividends. The fund has a weighted average maturity of 0.09 years (1.08 months) and a weighted average yield to maturity of 2.92%. As the portfolio’s current holdings turn, I expect the yield to continue to rise towards the 3-month market rate of 4% by the end of the year.

Summary

Inflation remains persistently high. The Federal Reserve is under pressure to continue rate hikes until inflation data begins to weaken. It will probably take a few more months as the Core CPI and PCE are impacted by lagging rent inflation. To protect my portfolio from increasing volatility, I have exposure to US Treasuries through the SGOV ETF.

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