Inflation Threats Make Yield Curve ETFs a Top Trade

Key Points

• As inflation risks for the United States economy come back online, the trade for a yield curve steepening becomes the best alternative for investors to consider.
• These ETFs can exploit this trend, exposing investors to the current economic trend and potential path.
• Two specific sectors also stand out, offering different perspectives on whether inflation will return to the economy.

Most investors fail to adopt a hybrid attitude toward the stock market. This means some place too much weight on the fundamentals regardless of price action and charts. In contrast, others swear by technical analysis without considering the big-picture fundamentals. The best on Wall Street managed to make both of these disciplines a priority for their success.

Today, there is one way retail investors can learn to emulate these processes: through a simple example in the bond market and its relative price action to the rest of stocks and other asset classes. More specifically, investors should keep in mind how this price action reflects the current fundamental image of the economy, recently swept by excitement from the Federal Reserve (the Fed) cutting interest rates.

Price action in bonds like the iShares 7-10 Year Treasury Bond ETF NASDAQ: IEF and the iShares 1-3 Year Treasury Bond ETF NASDAQ: SHY will show investors that fears of inflation are taking over the market. This trend is amplified when the performance of the iShares Russell 2000 ETF NYSEARCA: IWM and the iShares S&P 500 Growth ETF NYSEARCA: IVW is checked.

How Yield Curve Steepening Impacts Inflation & Top Trades to Consider Now

The yield curve, which is made up of the ten-year bond yields minus the two-year bond yields, typically measures the economy's liquidity cycle. All investors need to know is that the curve has been negative for 23 months, meaning a heavy leveraging cycle for the U.S.

Now that the Fed is decreasing its balance sheet and starting to work toward deleveraging the economy, the curve is going up. The consequences will be seen through inflation pressures, and that’s where these bond ETFs come into play for investors to consider.

By default, if the curve steepens, ten-year yields will rise faster than two-year yields, and investors can profit from this trend through the right ETF exposure. This exposure is made up by buying the short-term bond ETF while selling (or avoiding altogether) the long-term bond ETF.

This way, as long as the Fed keeps on its current path, which is likely, relatively low-risk profits will be made during the cycle. With bonds aside, investors now need to consider what inflation might mean for different stocks and how their portfolios can be secured against it.

Top Sectors to Watch If Inflation Resurges: Where to Focus Investments Now

The Russell 2000 ETF has underperformed the growth ETF by over 10% during the past quarter, and there’s a reason the market is compressing small-cap stocks against growth stocks. If inflation does come back around, then small-caps will likely suffer the most, given their domestic exposure to rising costs.

On the other hand, large-cap growth stocks, namely technology stocks, will likely do okay. With enough international exposure and subscription software businesses, companies like Spotify Technology NYSE: SPOT, Alphabet Inc. NASDAQ: GOOGL, and even Meta Platforms Inc. (NASDAQ: META) could see a so-called “melt-up” in their stock prices.

This belief can be verified by checking in with Wall Street analysts, starting with those at Jefferies Financial Group boosting their Meta Platforms stock price targets to a high of $675 today. To prove these targets right, the company must deliver a rally of up to 15% from today’s price.

Then there’s the recent boost for Alphabet stock from Truist Financial analysts, who now see the stock going as high as $220 a share, or 30.4% from where it trades today. Probably the most aggressive boost in ratings came from Spotify stock, as KeyCorp analysts reiterated their “Overweight” rating and a $490 price target for a net rally of 25.5%.

On the other hand, some of the top holdings in the Russell 2000 ETF, such as Sprouts Farmers Market Inc. NASDAQ: SFM, have a consensus price target of only $104.4 a share, which calls for a potential 12.8% downside from today’s stock price.

That goes to show that even good and well-managed businesses could see some downside in the coming quarters as the yield curve steepens and inflation makes a potential comeback. Instead of taking the market price action’s word for it, investors can check what some of Wall Street’s best are saying.

Stanley Druckenmiller and Paul Tudor Jones both publicly stated that they are looking to go short the bond market and now recommend buying commodities across the board. This is a textbook example of a view that aligns with higher inflation expectations.