As inflation reaches its highest level in three years and the Iran conflict continues, Federal Reserve officials are watching closely to see whether rising prices become persistent enough to require interest rate hikes instead of keeping rates unchanged, as quoted on Yahoo Finance.
Inflation Hits Three-Year High
Fresh data reinforced the Fed's concerns. The Personal Consumption Expenditures (PCE) Index, the central bank's preferred inflation gauge, rose 3.8% year over year in April, up from 3.5% in March and marking the highest reading in three years.
Core PCE, which excludes food and energy prices, accelerated to 3.3% from 3.2%, signaling that underlying inflation pressures remain elevated.
Peace Deal Could Ease Near-Term Inflation Concerns
According to Deutsche Bank, a successful peace deal would likely reduce immediate inflation risks. However, economists caution that inflation could remain elevated if oil prices stay above pre-war levels for an extended period, per the same Yahoo Finance article.
Deutsche Bank Sees Long-Term Rate Hike Risks
Deutsche Bank Chief Economist Matt Luzzetti expects Fed policymakers to largely overlook near-term inflation pressures caused by higher oil prices, viewing them as a temporary supply shock.
Still, Luzzetti warned that longer-term risks remain. He believes inflation could prove more persistent than expected, the labor market could remain resilient, and the economy's neutral interest rate may be higher than current Fed estimates. Under such conditions, future rate hikes cannot be ruled out.
Hot Jobs Data for the Month of May
Nonfarm payrolls jumped a seasonally adjusted 172,000 for the period, down slightly from the upwardly revised 179,000 in April and far above the Dow Jones consensus estimate for 80,000, as quoted on CNBC. The unemployment rate held steady at 4.3%, as expected. Such hot jobs report fueled Fed rate hike bets.
Fed Officials Adopt More Hawkish Tone
Several Fed officials emphasized concerns about inflation becoming embedded in the broader economy. Federal Reserve Governor Lisa Cook said she is monitoring whether businesses pass higher energy costs on to consumers and whether workers demand higher wages in response.
While her base case remains that inflation will moderate without additional tightening, she noted that she is prepared to support rate hikes if inflation fails to decline in a timely manner.
Some Policymakers Still Expect Inflation to Cool
However, several Fed officials continue to believe inflation will ease without additional tightening. Fed Vice Chair Philip Jefferson expects inflation to moderate later this year as the effects of tariffs and energy-related disruptions fade, per the same Yahoo Finance article.
Bond Market Signals Tightening Bias
Financial markets are also reflecting concerns that inflation may remain stubbornly high. The yield on the two-year U.S. Treasury note—a key indicator of expectations for Fed policy—has remained near 4% in recent weeks.
ETF Strategies to Play Rising Yields
Play Floating Rate Bond ETFs
The floating rate bond has been an area to watch lately amid rising rate environment. Floating rate bonds are investment grade and do not pay a fixed rate to investors but have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of issuers.
Since the coupons of these bonds are adjusted periodically, these are less sensitive to an increase in rates compared to the traditional bonds. Unlike fixed-coupon bonds, these do not lose value when the rates go up, making the bonds ideal for protecting investors against capital erosion in a rising rate environment.
iShares Floating Rate Bond ETF FLOT (yields 4.59% annually) and iShares Treasury Floating Rate Bond ETF TFLO (yields 3.95% annually) are two examples in this category.
Time for Cash-Like ETFs?
We believe cash and short-dated fixed income may play a greater role in adding stability to a portfolio. This is especially true given that if the Fed keep on hiking rates this year and short-term bond yields will rise alongside. That would result in a similar rate for cash-like assets such as money-market funds.
Investing options include JPMorgan UltraShort Income ETF (JPST) (yields 4.29% annually), Invesco Global Short Term High Yield Bond ETF PGHY (yields 7.09% annually), and Fidelity Low Duration Bond Factor ETF FLDR (yields 4.43% annually). Such short-term bond ETFs also have lower interest rate sensitivity.Bottom of Form
Hedge Rising Rates With Niche ETFs
There are some niche ETFs that guard against rising rates. Simplify Interest Rate Hedge ETF PFIX (yields 10.19% annually) is one such option.
Short U.S. Treasuries
Plus, shorting U.S. treasuries is also a great option in this type of a volatile environment. The picks include ProShares UltraShort 20+ Year Treasury ETF TBT, Direxion Daily 20+ Year Treasury Bear 3x Shares TMV and ProShares UltraShort 7-10 Year Treasury PST.
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ProShares UltraShort 20+ Year Treasury (TBT): ETF Research Reports
ProShares UltraShort 7-10 Year Treasury (PST): ETF Research Reports
Direxion Daily 20+ Year Treasury Bear 3X ETF (TMV): ETF Research Reports
iShares Floating Rate Bond ETF (FLOT): ETF Research Reports
iShares Treasury Floating Rate Bond ETF (TFLO): ETF Research Reports
Invesco Global ex-US High Yield Corporate Bond ETF (PGHY): ETF Research Reports
Fidelity Low Duration Bond Factor ETF (FLDR): ETF Research Reports
This article originally published on Zacks Investment Research (zacks.com).