Editor’s note: This article was corrected to reflect that core PCE was unchanged at 3.0% in August.
A cooler-than-expected reading on the Federal Reserve’s preferred inflation gauge has strengthened the case for Treasury bonds, after August data came in below economists’ forecasts, helped largely by downward revisions to prior months.
The Personal Consumption Expenditures (PCE) price index rose 0.3% month over month in August, below the 0.4% consensus estimate. Core PCE rose 0.2%, versus expectations of 0.3%.
On an annual basis, core PCE held at 3.0% in August, unchanged from July’s downwardly revised rate and below the 3.3% forecast, which was based on July’s pre-revision figure. The data pushed the two-year Treasury yield down about 4 basis points to 4.84%, as traders reassessed the path of Fed policy.
Why TLT Has More to Gain From Falling Yields
Lower yields put the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) directly in focus.
Unlike an equity ETF, TLT’s sensitivity to interest rates comes from the bonds it owns. The fund invests primarily in U.S. Treasury bonds with remaining maturities of more than 20 years. Because those bonds have long maturities, their prices can move significantly when market yields change.
TLT currently has an effective duration of roughly 15 years. Duration provides a useful approximation of how much a bond portfolio’s price changes when yields move. In simple terms, a 1-percentage-point decline in yields would imply roughly a 15% increase in TLT’s underlying bond prices, before accounting for other factors. A 0.10-percentage-point decline would therefore imply roughly a 1.5% price increase, all else equal.
That makes TLT particularly relevant when inflation data changes expectations for the Fed and, consequently, Treasury yields.
The iShares 7-10 Year Treasury Bond ETF (NASDAQ:IEF) offers a shorter-duration alternative. Because its Treasury holdings have less time remaining to maturity, its price is generally less sensitive to the same yield movement.
The Catch: Inflation Is Still Above Target
The PCE report isn’t an outright victory for the bond market. Core inflation at 3.0% remains a full percentage point above the Fed’s 2% target, while second-quarter GDP growth was revised up to 2.2% from 1.5%.
Energy prices also jumped 2.3% in August, with gasoline and other energy goods rising 4.4%.
That leaves TLT’s next move heavily dependent on whether cooler inflation readings lead to a sustained decline in long-term Treasury yields. If yields continue falling, TLT’s long duration gives it substantially more price sensitivity than intermediate-duration Treasury ETFs such as IEF.
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