IEF: Executing The Powell Put – iShares 7-10 Year Treasury Bond ETF (NASDAQ:IEF)

The Federal Open Market Committee (FOMC) just concluded their June 18-19 meeting as reported by Seeking Alpha. The Federal Reserve Chairman Jerome Powell, in his prepared remarks after the meeting, has made clear that the case for more accommodative policy has strengthened and that the FOMC will take into consideration trade and global growth concerns. As a result, we believe that the Fed will effectively act to offset the potential economic impact of more volatile financial markets. Consequently, we suggest the iShares 7-10 year Treasury Bond ETF (NASDAQ:IEF) as one straightforward way to act on this reality.

This article will briefly recap some key points from the June 2019 FOMC meeting, describe the key data points the Fed considers in its decision-making process, and provide more details regarding the IEF.

The Fed’s key considerations

The Federal Reserve has two objectives: full employment and a symmetric 2% core inflation. The two economic indicators that measure those two objectives are seen in the graph below.

Data by YCharts

The Fed views the sustainable unemployment at 4.2% (based on the long-run median projection). An unemployment rate of 3.6% is a call for a more hawkish stance (i.e. tightening monetary policy environment) if viewed on a standalone basis.

Similarly, the Fed expects the Core Personal Consumption Expenditure (PCE) inflation to normalize at 2.0% in due time (as per Jerome Powell’s press release) which suggests that no further policy action is needed:

After running close to our symmetric 2 percent objective for most of last year, inflation declined in the first quarter. Data since then show some pickup. Participants broadly see inflation moving back up toward our 2 percent objective, but at a slower pace than had been expected.

Simply put: the key metrics on its own do not have a dovish (i.e., loose monetary policy) bias. If anything the key metrics are pointing towards a hawkish bias as the more appropriate policy stance.

Of course, the Fed isn’t simply looking at these backward-looking metrics. As Jerome Powell describes (in the same press release):

Because there are no definitive measures of inflation expectations, we must rely on imperfect proxies. Market-based measures of inflation compensation have moved down since our May meeting and some survey- based expectations measures are near the bottom of their historic ranges

Key examples of variables that the Fed could be looking at would be the Treasury Inflation-Protection Securities (NYSEARCA:TIP) breakeven rate and the U.S. one-year ahead consumer inflation expectations survey. A three-year graph for these variables are in the chart below.

Data by YCharts

These ‘forward-looking’ metrics are signaling lower inflation which can explain why the Fed is turning strongly dovish. On the other hand the survey-based inflation expectations are still running above the Fed’s 2% target and the market-based TIPS breakeven rate is not exactly a strong predictor of forward-looking inflation.

Again, the Fed recognizes that forecasting the trajectory of these objective variables is an imprecise exercise. We agree with that sentiment and look towards overweighting the historical variables vis-a-vis the forward-looking ones. We are especially wary of the market-based approaches.

Given that backdrop, we now expound on the latest FOMC meeting.

Economic and Fed funds rate projections

The quarterly FOMC meetings are accompanied by updated economic and fed funds rate projections – the latest one seen in the table below:

Source: The Federal Reserve

Investors focusing on the median projections of FOMC members will find a perplexing pattern: Gross Domestic Product (GDP) projections are shaded up from 1.9% to 2.0% in 2020 and unemployment projections are shaded down by 0.1% from 2019 onwards but both inflation and core inflation projections are reduced in 2019-2020 by 0.1-0.3%. Basic macroeconomic theory suggests that stronger GDP growth generates a more inflationary environment; but the FOMC members continue to expect the unconventional going on in the U.S. economy.

More importantly, the median projection for the Federal funds rate falls to 2.1% in 2020 before heading back up to 2.4% in 2021 and 2.5% over the longer-term. In effect, the Fed has effectively turned around from its last forecast in March wherein it still expected to do one more 25 bps rate hike in 2020 before the final 25 bps rate hike in the longer-term. Similarly, the Fed is expecting not only to keep rates on hold but to actually cut them in response to a potential slowdown in the economy. Recall that just six months ago the Fed raised rates for the fourth in 2018 and is projecting at least two interest rate raises in 2019. Strangely enough, the interest rate cut doesn’t seem to be aligned with their economic projections – note how GDP growth is still pegged to meet 1.9% in the longer-term and PCE inflation to hit the symmetrical 2.0% target in the same time period. So if the economics aren’t driving the monetary policy then what is?

Jerome Powell’s statement

In the press release coming from Fed Chairman Jerome Powell, the rationale for a more accommodative policy becomes clear. Here is the key paragraph:

While the baseline outlook remains favorable, the question is whether these uncertainties will continue to weigh on the outlook and thus call for additional monetary policy accommodation. Many FOMC participants now see that the case for somewhat more accommodative policy has strengthened.

Jerome Powell describes these uncertainties in greater detail (in the same press release):

Apparent progress on trade turned to greater uncertainty, and our contacts in business and agriculture report heightened concerns over trade developments.

Essentially the FOMC expects economic growth to be sustained, the labor market to remain tight, and inflation to eventually meet the target; but the FOMC will be willing to cut rates on the back of uncertainty related to trade.

Herein lies the problem: getting the economic projections correctly without accounting for last-minute trade deals and supply chain implications is hard enough – having an administration that spews uncertainty on a daily basis and incorporating the potential impact of those uncertainties will be impossible for any institution. I suspect that the FOMC’s likely bias is to cut rates in response to these uncertainties as to preempt the potential slowdown resulting from them. Note that the Fed changed the language of their inflation target from simply meeting the 2% core PCE inflation to

We are firmly committed to our symmetric 2 percent inflation objective, and we are well aware that inflation weakness that persists even in a healthy economy could precipitate a difficult-to-arrest downward drift in longer-run inflation expectations

A symmetric 2% inflation objective means that the Fed will be willing to tolerate inflation above 2% considering that inflation has run well below 2% in the last decade. Said logic is supportive of a Fed bias to cut rates rather than hold them steady in the face of uncertain (but not yet economic data affecting) events.

So what instrument should we consider to take advantage of this shift in Fed positioning?

The iShares 7-10 year Treasury Bond ETF

The IEF is an exchange traded fund launched and managed by BlackRock, Inc. (NYSE:BLK). It seeks to track the performance of the ICE U.S. Treasury 7-10 Year Bond Index via representative sampling. It has 18 holdings and a cash position of approximately 0%.

While there are various ways to incorporate a long view on U.S. yields (ranging from the type of instrument to the duration), we believe that the most straightforward approach is to invest in the tenors that are most liquid – the 7-10 year space.

Most investors – from pension funds in Southeast Asia to hedge fund managers in Europe – will generally be able to invest in the ten-year U.S. Treasury bond and will generally do so to express a view on the rates market. Conversely, the longer tenors, while providing higher returns (subject to higher risk) typically meet tenor and / or duration limits. On the other hand, the shorter tenors (having lower duration) may not be worth the transaction costs. Hence, the 7-10 year is the sweet spot for this type of transaction.

So when do we actually trigger this investment?

I can’t forecast the future – especially the events that will be expected to get the FOMC to move on the monetary policy. I doubt anyone can except perhaps President Donald Trump who can resolve, or more likely initiate, these uncertainties. Having said that – we need to be able to express our investment ideas. Investors with high-conviction and proprietary views on deteriorating economic data or higher political uncertainty (especially on matters related to trade) should take advantage of the Fed’s committed role to combating financial and business confidence uncertainty. Whereas we used to simply expect the Fed to take policy action on economic expectations, now we simply have to take advantage of this new reality. As the ETF replicating the most liquid group of U.S. Treasury securities, the IEF is the most straightforward choice in this new paradigm of the FOMC.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.