US Treasury 2 Year Note ETF (NASDAQ:UTWO) contains simply Treasuries with a 2-year maturity and a 4.875% coupon rate and some cash. It’s a fixed income ETF that comes at the reasonable expense ratio of just 0.15%, which is in line with most Treasury ETFs that you can buy from the various investment platforms, including iShares. It’s a play on a secure cash flow from underlying Treasuries, as well as a capital appreciation play if prevailing rates were to fall quicker than expected. Given the pricing in of rapid and nearing price cuts, we wage that capital appreciation isn’t likely. In particular, the self-unfulfilling prophecy of the markets pricing in lower rates sooner is a structurally undermining factor of the Fed policy that just makes timelines for increasing rates longer, and lessens the economic value of the underlying instrument. We explain.
Loosening Financial Conditions
When markets start to bid up long-duration Treasuries, speculating that the Fed rate cuts are coming in after seeing factors like slightly looser job market conditions, although that’s arguable given the unemployment readings, they have a hand in actually undermining the Fed transmission mechanism into the economy.
Particularly, the downward revisions in longer-term rate expectations have an especially big effect on financing conditions as it determines the conditions to purchase larger ticket items, and frees up immediate income to be able to maintain the high levels of monetary velocity that is to blame for the seemingly limited effect of the current Fed rate hikes on economic activity which has remained belligerently strong. The 20Y revisions went down by about 0.5% over the last month.
Bottom Line
We have concerns that these bets, in addition to contributing to a higher likelihood of longer high rates or even higher rates, may have been somewhat misplaced in the first place.
While the JOLTS data showed some initial signs of a cooling labour market, it was by no means definitive. Unemployment rates have actually fallen, and by the Phillips Curve logic, which should work in a non-zero rate environment, that should also mean more inflationary pressure.
Moreover, the JOLTS data quit rates, which signal somewhat the reticence of people to find different jobs, may have been overstated by the demographic constant which is that there is a bulge of people in the US on the cusp of retirement, who will leave the workforce permanents as a hit to the labour supply.
Beyond the JOLTS data, it is in the Fed plan currently to bring down inflation quickly. Even if labour market dynamics were cool enough, where expectations about inflation lie is extremely important for how economic actors budget their upcoming price increases and baseline wage increases. Inflation expectations for the next 365 days are staying at 3.1%, where this time last year they were 3.4%. Expectations are a much more effective signal of where inflation is going to be than what’s happening currently in the labour market, since expectations, independent of the economic situation, can set inflation levels. The fact that the changes in inflation expectations since last year have been limited, signals anchoring at these higher rates. Incidentally, we think consumers are right since we are in a more inflationary world with more economic nationalism, smaller productive workforces and a host of other factors that limit supply growth.
Overall, UTWO, along with the general fixed income and equity markets, are likely to be too optimistic about the pace of rate decreases and both markets are likely to remain correlated and be faced with downside. While UTWO at least has a duration less than 2 years, we think it will suffer along with the rest.
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