The iShares Core U.S. Treasury Bond ETF (BATS:GOVT) is a (virtually) zero-credit risk way to get exposure to longer duration US Treasury bonds for allocators looking to make high level macro-based bets. Today was the day that CPI figures make their way out for the US, and while things are easing, we see some spectres on the horizon in commodity reflation that could affect the rate cycle expectations. Markets are probably not considering these oblique factors, so we’re staying away from longer-duration fixed income right now like GOVT.
Why No GOVT?
GOVT has pretty high effective durations at 6.13 years. It will be a sensitive ETF to revisions in the length of the rate cycle.
Today’s inflation figures were good, and showed continuing easing, however shelter and food inflation continues to drive the figures, and while that was to be expected, it is a dangerous form of inflation because it could affect inflation expectations. The Michigan Inflation Expectations report came at pretty low levels of 2.9%, indicating that consumers understand that figures are going to be lapped and that inflation should be somewhat of a one-off, but this could change if food and shelter continue to be inflation drivers.
Commodities of oil and gas also contributed to the rising MoM figures, showing sequential inflation. This highlights a potential spectre that could substantially revise somewhat optimistic expectations for the rate cycle. In particular we see the first obvious risk that oil is going to be supported by a Chinese recovery as COVID-zero is over. Also other commodities too, like steel, steel products and iron ore.
A more complex one is around Russia cutting its production substantially as it responds to the price-caps on oil and oil products instituted on Russia. The price caps aren’t a hard hit directly to Russia, since you can still indirectly by Russian oil just not with European vessels and insurance, which can be a problem for traders. Also the price caps still mean better prices for Ural oil than what they are getting with India. This is more Russia retaliating to Europe. Anyone can see that these trade retaliations could reflate oil, but that’s why it’s probably priced in. There’s a more second order issue with Russia reducing its production which is that their permafrost based wells could gel-up and cause a water film to freeze and damage the wells. With much less access to infrastructure now to deal with these wells could become damaged and essentially irreparable. Continuous production avoids this risk, but production reductions could mean permanent hits to a not-irrelevant almost a point or so of global supply, with the risk becoming greater as production continues to fall with further retaliations.
Bottom Line
There are some risks with the debt ceiling in the US that actually relates to credit quality questions around GOVT, but these are remote and for another article and time, but the main issue is that inflation is still here, even on a core level, and commodity price reflation could become a problem, and possibly a permanent one too.
Overall, best to avoid long-duration instruments like GOVT.
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