Torsten Asmus
The iShares 3-7 Year Treasury Bond ETF (NASDAQ:IEI) is a long-ish duration ETF, with an effective duration of 4.42 years, meaning a decent amount of sensitivity to unitary changes in rates. We are nearing the end of rate hikes, but markets may be off their mark, even bond markets when it comes to longer-term rates, which are going to concern equally long-dated bonds. We think inflation is going to be quite sticky, and our higher real yield view is not consistent with recent market developments, and are therefore wary of the recent optimism.
Macro
The ETF has recovered to levels closer to those they were trading at in early 2023 after the initial regional banking concerns hit markets broadly. The situation is that a slew of goldilocks data and general attitude that the Fed is going to start cutting rates has put some pep in the long-duration bond market.
We have distinct concerns, which are that while inflation appears to be slowing, and there’s no doubt it is, it continues to be owed to relieved base effects, even if slighter now that we’ve lapped the period before the Ukraine war’s outbreak. Even still, the levels remain above policy levels, and the Fed, which has been extremely careful to not undermine its own credibility by being true to its word, will essentially surely keep rates higher for longer.
We assume that the Fed jumping the gun is essentially impossible. We think that even if the economy seems poised for a soft landing so long as the Fed reduces the throttle, it may decide to hurt the economy at the cost of maintaining the credibility to follow through with policy statements and decisions. At any rate, there is no evidence yet to support the conclusion that inflation won’t be sticky at its current above-3% level and that a soft landing would be possible.
The recent recovery in expectations strikes us as exhaustion from negative sentiment, more than it has anything to do with the data, which continues to show that inflation is too high and that the labour market is still tight. Another thing of importance is that the pre-retirement cohorts are pretty large in the US, representing almost 12% of the population. So real economic decline is against the clock of a smaller workforce, making the labour market tightness tougher to solve.
Today is the JOLTs data, and the labour market data in the coming week are going to be important to assess whether the labour choke is loosening, since the labour data leads inflation data and is the bigger focus. We suspect that the optimism in markets, especially bond markets, which actually improves credit conditions and supports the economic activity that the markets are betting against, is going to be met with the realisation that fundamentally inflationary factors like deglobalisation, worker unrest and unionisation, and generally higher levels of global conflict as well as core tit-for-tat pricing action and underlying money velocity, will be keeping market actors’ expectations for inflation higher than target, and will therefore assure that inflation stays higher than target. A lot of commodity deflation has even run its course and it hasn’t been enough to bring down rates.
In fact, there are some commentators who think that the inflation rate may never come down to 2%, without a total crash in the economy, no matter what the Fed does with rates. We think this is extreme since there are many factors, including potential substantial unemployment as debt refinances at higher rates in the corporate sphere, that could quite easily bring down inflation, but of course at the expense of the economy.
IEI Breakdown
IEI is a low expense ratio ETF at 0.15% that gives investors exposure to (in principle) riskless Treasuries with an effective duration around 4.4 years. The current yield curve shows that rate expectations for 4-year maturity debt has gone down around 0.3% compared to 1 month ago, which is quite a lot, hence the re-rating in price upwards. We think that continued inflation, and evidence that the economy is not slowing down sufficiently at current rates at this point in time, will eventually erode these expectations and start impacting ETFs like IEI which keeps a portfolio between 3-7 years in maturity. Markets know that the Fed’s objective is to bring down dangerous inflation at this point and to do so rapidly as expectations risk anchoring if they don’t. The last leg of inflation would always be the toughest to break, so it’s at this point in time that we should be the most uncertain about how successful the rate campaign has been and will be, not confident that everything is going to be fine. With so much excess to burn, we aren’t getting impatient and feeling that higher for longer has already happened.