Can you profit from falling inflation?

15.11.2022 10:39|Conotoxia Ltd Analyst Team

Recent data on the decline in U.S. inflation from 8.2 percent to 7.7 percent may have reversed investor expectations. It seems that the Fed's announcement to fight by all means against inflation did not scare investors. In that case, have we already seen the peak of price increases, and if so, can we profit from it and how?

Bonds as an investment in rising inflation

A bond is a type of debt issued by companies and countries that could be traded on the market. By its structure it is largely linked to the level of interest rates. Currently, interest rates (lending rates) are raised to beat inflation, which leads to a drop in bond prices and increases in their yields. In addition, the longer the term to maturity, the greater the risk of interest rate changes.

Bond ETFs a hedge against the crisis?

After the last FOMC meeting, rates were raised by 0.75 percentage points, the largest increase in the entire cycle, which started at 0.25%, now reaching 4.00%. Assuming that we would see a change in the Fed's monetary policy and cut interest rates to, say, 1.5%, in order to bail out the economy, what kind of returns would we get for the sample funds?

The iShares Core U.S. Aggregate Bond ETF (AGG) is a fund that gives broad exposure to U.S. bonds rated BBB or higher (considered very safe). It holds as much as 74.43 percent of bonds with the highest AAA rating, and has an average Effective Duration of 6.41. This ratio takes into account interest paid (coupons) and is an approximation of price changes. For example, if the level of interest rates were to fall to the level described (a change of 2.5 percentage points), the price of the bond would rise by about 16 percent. Because of the current rate hikes, this fund has not fared well, crediting a decline in value of more than 14 percent since the beginning of the year (the S&P 500 index has fallen 16.42 percent over the same period).

Source: MT5, AGG, Weekly

The second fund is the Vanguard Intermediate-Term Bond Index Fund (BIV), which holds 58 percent of U.S. government bonds with maturities between 5 and 10 years. The average effective maturity for this fund is 6.01, which would give an increase in value for the described example of about 15 percent. The performance of this fund since the beginning of the year has been similar to the one previously discussed (down 14.74 percent), but in comparison this ETF seems to have a slightly lower risk.

Source: MT5, BIV, Weekly

The last fund is the iShares 20+ Year Treasury Bond ETF (TLT), which consists of U.S. government bonds with maturities of more than 20 years. The average effective maturity is 17.66. For the described example of a 2.5 percentage point drop in interest rates, the fund could rise in value by about 44 percent. Since the beginning of the year, the fund's value has fallen by more than 30 percent.

Source: MT5, TLT, Weekly

What's next for inflation?

In order to answer the question "what can affect the decline of inflation?", we should define what is currently causing it. There are many factors that could affect the level of inflation in a country, including demand, or commodity prices. Currently, it seems that it is the latter factor that has the greatest impact on the level of inflation, but over the past months we have noticed significant declines in commodity prices, including oil prices have fallen by more than 30% since their peaks.

 

Author: Grzegorz Dróżdż, a Market Analyst of Conotoxia Ltd. (Conotoxia investment service)

Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75,21% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Trading on CFDs is provided by Conotoxia Ltd. (CySEC no.336/17), which has the right to use the Conotoxia trademark.