After decelerating in last year’s final three months, inflation ticked up in January. Tuesday’s consumer price report jarred stock investors, who responded in the aftermath by selling shares. The iShares Core S&P 500 UCITS ETF (CSPX) fell by as much as 1% on Tuesday morning.
But by the end of the day, the ETF had recovered, finishing unchanged. Sure, the CPI data for January was not ideal but investors signalled they are confident the disinflationary trend that began late last year is still in place.
Combined with the super-strong jobs report from earlier this month – which showed the unemployment rate hitting a five-decade low – that confidence is why SPY is trading 15% above its bear market lows and why the Invesco QQQ Trust (QQQ) is up by 18% from its trough.
But even as the stock market brushes off the inflation and jobs reports (or even interprets them in a positive light), the same can’t be said of the bond market.
Immediately after the release of the CPI report on Tuesday, the two-year Treasury bond sold off, pushing its yield to a three-month high (bond prices and yields move inversely). At 4.61%, the two-year yield is just a hair below the 15-year high of 4.72% set in November.
The yield moved up because the recent data we have seen recently on jobs and inflation suggest the Fed will keep hiking rates.
Contrary to the optimistic expectations of several weeks ago, the rate hiking cycle probably is not over. Probabilities based on fed fund futures imply that the central bank will hike rates another three times in March, May and June.
Those expectations could change, of course. Every economic data point seems to shift the market’s belief in what the Fed is going to do and how long there is to go before the central bank finally calls it quits on rate hikes.
But the fact of the matter is that time and time again, the market has underestimated how high the central bank is willing to take interest rates. Yes, the central bank will stop at some point, and probably in the not-too-distant future.
Maybe it will be at 5%, or 5.5% or even 6% – no one, not even the Fed, knows for sure.
For bond investors, that’s a bit of a quandary. Rising interest rates push prices for bonds lower, so an uncertain peak for rates translates into an uncertain trough for prices.
Yet not all bonds are impacted by rising rates to the same extent. Short-duration bonds – those that pay investors back faster – are less sensitive to interest rate fluctuations.
In fact, this is an ideal environment for short-duration bond ETFs. They offer investors high and rising interest rates while insulating them from downward lurches in prices caused by larger-than-expected Fed rate hikes.
This article was originally published on ETF.com