tadamichi
The iShares 1-3 Year Treasury Bond ETF (NASDAQ:SHY) is a relatively low duration zero credit risk Treasury ETF that is quite dependent on the changes in rate expectations over the 1-2 year horizon. While headlines are saying CPI is moderating, it obviously remains too high and the issue is not being solved. What is worse is that PPI is up, which just means that there is still more inflation to be digested from upstream. While there was a labour market “cooling”, it’s still very hot. We haven’t seen any real economic impacts, yet, that will be required to set inflation right in the US. The yield curve expects some rate cutting within a year from now. We think it’s a coinflip as to whether that happens or not, so we’re not buying anything other than ultra-short duration fixed income.
SHY Breakdown
SHY is not very complicated. Zero credit risk (in principle) as it owns only Treasuries. Effective duration is 1.8 years, which implies about that much factor of sensitivity in price to a small change in rates. The expense ratio is 0.15% which is around in line for fixed income ETFs.
The yield curve currently expects a 5.2% prevailing rate in the US as of one year from now. Crudely, that means it expects maybe one 25 bps rate cut some time over the next 12 months. By two years from now, it is expecting around 50 bps in total rate cuts. The two-year expectations seem more reasonable, but we are worried about more trouncing of shorter term expectations. We think there’s no assurance that a rate cut will happen in the next 12 months.
Firstly, there is no reason for inflation to be falling based on the economic data. Since we are past the last decade of the “new normal”, we can start to rely on Phillips Curve logic again. There remains high levels of employment, so there shouldn’t be any change in inflation. The was a slight uptick in unemployment, but it verges on negligible, especially as employment rates in general are figures that are subject to so many assumptions.
The other issue is empirical, which is that we continue to see data that supports the idea that inflation has hit a floor on the way down, which makes sense because inflation is naturally sticky. For some reason, headlines talk about inflation as if it’s becoming less of a problem, yet it lies way ahead of the 2% policy mark at 3.4% YoY. While it’s true that some categories of inflation are down, like eggs and certain food products, grains are up and so is shelter, which also matter a lot of inflation expectations. On the matter of inflation expectations, they remain above 3%; therefore inflation will be above 3%, since the #1 cause of inflation is the expectation of inflation.
Importantly, PPI figures support the idea that any month by month improvement we see in the short term will be rebuked by higher producer prices, which continue to rise meaningfully on the back of service inflation which continues due to strong labour markets and a later wave of union action that came about a year after the initial goods inflation caused by the disruption of the Ukraine war and also some pandemic effects.
Bottom Line
Every month in which CPI proves more stubborn will be a month where you should not have been invested in SHY. We think that both high inflation expectations, but also PPI effects, are going to disappoint markets for the time being. We see no positive trends yet. The only thing to look out for are maturity walls. Liability management is up at the advisors, which signals the beginning of considerations by corporates of what to do about the maturity walls. If the maturity walls impact bottom lines enough to spur more layoffs, we think that would be the signal to start investing in moderate duration fixed income Treasuries, avoiding any credit risk since credit spreads remain too low. Until then, a pass.
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