USFR: Hiding Out In The WisdomTree Treasury ETF

With yet another slightly hotter than expected CPI print for the month of September, speculation that the Federal Reserve could keep interest rates higher for longer is once again finding an audience in the zeitgeist. In fact, September is now the third consecutive month that the year-over-year rate of change in the CPI has been above the June figure of 3.1%. In my view, this is a clear indication that inflation is far from over.

Savers Are Winning Again

Even though consumer price inflation is still much higher than it was at any point in the eight years leading up to COVID lockdowns, the big shift that we're seeing in the treasury market has created a situation that we haven't generally had in the last 15 years; savers are getting rewarded again:

Over the last four months, the average spread between the year-over-year rate of change in CPI and the yield on the US 3-month has been over 2%. The last time that happened was 2007. I think there are a few ways we can look at this. On one hand, the ZIRP era has not been normal, and it's good to see that capital once again has a real cost. On the other hand, incentivizing saving through higher yields could potentially have a negative overall impact on the economy - which may ultimately drive a reversal in those yields.

As someone who has dedicated quite a bit of time to covering assets like Gold (XAUUSD:CUR) or Bitcoin (BTC-USD) for Seeking Alpha over the last several years, I'm very familiar with the "inflation hedge" stories associated with those assets. But, I'm also a proponent of diversification. And I believe we're now in an environment where getting defensive might actually make quite a bit of sense.

Getting Defensive

The reason why Bitcoin even exists is because of bailouts and the ZIRP era. With interest rates at zero and savers getting largely hosed when adjusting for inflation, everyone has been pushed out on the risk curve in an attempt to protect their purchasing power. But again, we have a different environment currently, and that necessitates looking at alternatives to how we've been investing over the last 12 to 15 years.

Equities broadly don't look all that attractive to me up here. In part because a defensive-minded investor isn't generating a meaningful dividend from holding broad stocks. Since stocks could have an aggressive repricing lower if we are indeed in or approaching a recession, even the individual stocks to that due offer a respectable yield may not provide a positive total return when accounting for the potential capital loss if the broad market goes down. The dividend yield on the S&P 500 is currently 1.6%:

Not only is 1.6% well below the historical mean of over 4%, but the lack of a dividend from the S&P is probably a pretty clear indication that equities are overvalued. While the dividend yield on the S&P 500 may not be as egregiously low as it was at the peak of the dot com bubble, the ratio for stocks compared to bonds is very telling:

The S&P 500 Index divided by the Total Return Bond Index is currently 1.46. To give some historical context for what that means, the last time equities were beating bonds to this degree was the top of the dot com bubble. There are two ways this ratio can adjust lower; bonds can get a bid or equities can sell off. To be clear, in May 2000 when the S&P/Bond ratio was 1.46, bond yields were lower eight months later. That certainly could happen again. But if consumer price inflation remains sticky, I think it's more likely that rates will stay higher even if equities take a tumble.

Hiding Out In The WisdomTree

However, even if bonds reverse and rates do go down, I don't think that will happen before we start to see economic deterioration reflected more in the BLS and BOE data than it currently is. And given what we're seeing in the yield curve, I believe it makes a lot of sense hiding out in short duration treasuries:

Beyond money markets or buying the treasuries directly, investors who may want simple access to shorter term US debt have a variety of different options in the public markets through ETFs. I looked at a handful of these and ultimately decided to go with the WisdomTree Floating Rate Treasury ETF (NYSEARCA:USFR) purely because the total return over the last 12 months has been a little bit better than similar alternatives:

At a 4.94% total return over the last year, USFR has been a solid approach to buying short term treasuries in something like a traditional IRA. What I like about this approach is it simply allows us to get paid while we wait for the next move in the equity market. The fund has terrific liquidity with over $18 billion in assets under management and a small expense ratio:

• AUM: $18.4b
• Expense ratio: 0.15%
• 12 month total return: 4.94%
• Forward yield: 5.33%

More importantly, because the ETF is designed to fluctuate with 3-month treasury bill issuance, if yields keep going up, the fund return will adjust higher as well. The current holdings have a weighted average coupon of 5.57%:

Going long USFR is essentially shorting bonds. We want the yield to go higher, but it doesn't even have to. Inflation is still high. As long as the fed keeps rates up to combat that inflation, the yields on USFR can stay right where they are and USFR holders should come out ahead.

Risks

The case against parking capital in an ETF like this is that other assets could simply outperform if the real yield turns negative again. In that scenario, the total return from USFR will likely underperform gold and potentially even certain equities. Furthermore, if there is a reversal in the market and bonds catch a bid, the monthly return from ETFs like USFR will decline. That could make USFR unattractive versus other bond ETFs that may benefit more from a capital appreciation standpoint.

Another risk that I view as highly unlikely is the possibility that the US government could default on its obligations and stop paying debt holders. Even though the federal government is clearly in a very dangerous position from a public debt standpoint, I do think the idea of default is very unlikely.

Summary

This is a pretty straight forward idea. Investors have been pushed far out on the risk curve over the last 15 years or so because of the ZIRP era and the lack of a meaningful return on savings. That is no longer the case. Equities are overvalued by several different measures. While I personally have quite a bit of gold, I'm not opposed to diversifying with treasuries if there is a real yield, and we finally have that today. Given the current yield curve, I think parking capital in USFR is a great play, provided the real yield above inflation can maintain current levels. USFR is a buy in my opinion.