At its June meeting, the Federal Reserve opted to reduce its monthly mortgage and Treasury bond purchases (or quantitative easing) to $35 billion each month from its previous level of $45 billion. I discussed in a recent Blog post that this action continues the Fed’s shift in monetary policy from “excessively easy” to “easy”; but many wonder if the central bank is moving too slowly.
What do I mean by this? Over the past five and a half years the Fed has put an unprecedented amount of stimulus into the economy, all in an effort to jump start growth in the wake of the Great Recession.
As the economy recovers, the question becomes when the Fed should remove that accommodation. Move too soon and they risk stifling growth. Move too slowly and it risks igniting inflation. For bond investors inflation represents a significant market risk, as it generally leads to higher interest rates and declining bond prices.
Over the past few weeks the market’s expectation of short term inflation has been trending up. The consumer price index (CPI) posted a year-over-year change of 2.1% and a month-over-month change of 0.4% in May and we have seen an increase in oil and gold prices, as well as the Fed’s indication that it will continue to slowly withdraw stimulus from the economy. At BlackRock, we think inflation will increase only moderately through the end of the year, though we recognize that many investors are looking to prepare their portfolio for a potential rise in prices.
While we still advocate caution towards Treasury Inflation Protected Securities (TIPS), investors looking to hedge against higher rates that result from inflation may want to consider very short duration. Shorter duration investments have less interest rate risk, and thus less inflation risk. Right now we advocate for very short duration exposures — zero to less than two years.
Two potential solutions for building exposure to very short duration within your portfolio include the iShares Short Maturity Bond ETF (NEAR), which has an effective duration of 0.85 years, the iShares 1-3 Year Credit Bond ETF (CSJ) which has an effective duration of 1.9 years. Another consideration is the iShares Floating Rate Bond ETF (FLOT), which has an effective duration of 0.15 years.1