‘Floating’ a Solution for Inflation

It’s probably a bit of an understatement to say that the ‘inflation trade’ has gripped the money and bond markets in recent weeks. Indeed, U.S. Treasury (UST) yields have risen in a rather visible fashion, as anxieties surrounding a more embedded inflation backdrop has taken hold.

So, how did we get here you may ask? Rising energy prices emanating from the Middle East war has certainly been the catalyst. At first, just the swiftness and magnitude of the increase in crude oil prices captured the money and bond markets’ attention. However, the second leg of the heightened level of anxiety was provided by the recent CPI and PPI reports for the month of April. In each instance, the results came in ‘hotter’ than anticipated and added more fuel (pun intended) to investors’ fears that inflation could become a broader problem.

On that latter point, it was the performance of the core inflation readings that raised the alarm. Once again, within both reports, the year-over-year increases were higher than consensus estimates, but it was the PPI result that stood out in particular. Specifically, PPI, less food, energy and trade services spiked by +4.4%, the largest increase since February 2023. As a result, the bond market became more concerned that price pressures were spreading beyond just energy-related products.

This last point is important because even if the Middle East war were to come to an end and energy prices began to reverse course, the elevated inflation setting could be ‘sticky’ and remain a more challenging backdrop for the Fed.

In terms of upcoming monetary policy, as we have written in a series of Warsh-related blogs this year, the new Chairman will follow the data, and at this point in time, that data is pointing to a Fed that appears to be done cutting rates, and is on hold for the rest of 2026.

I still don’t think the Fed is close to a rate hike, but for the upcoming June FOMC meeting, a shift in the language of the policy statement from an easing bias to one of a ‘balanced’ outlook seems to be the most likely scenario. However, the fed funds futures market has now fully priced in a rate hike for the end of this year, a remarkable shift from its pre-war status of discounting two to three rate cuts for the same timeframe.

Why Does This All Matter?

It all comes back to the U.S. Treasury (UST) market where, the ‘inflation trade’ has taken hold, and yield levels across the fixed coupon maturity spectrum have risen in a rather visible fashion since the end of February. Admittedly, a resolution in the Middle East would more than likely create a knee-jerk rally for Treasuries, but I don’t feel it would be a ‘sustainable’ rally given the resilient economic backdrop and still ‘sticky’ inflation potential.

Solution

Remember, for the bond market, inflation is essentially viewed as a type of kryptonite. In other words, increasing prices actually ‘eats away’ at an investors’ fixed income stream.

So, how can a bond investor combat the ‘inflation trade’? One answer: UST Floating Rate Notes (FRNs). Treasury FRNs aim to mitigate the duration and volatility risks of fixed coupon maturities, while also serving as a hedge when the money and bond markets are pricing in the potential for Fed rate hikes. The WisdomTree Floating Rate Treasury Digital Fund (FLTTX) allows investors to access this important asset class and can contribute to a fixed income portfolio.