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Fed Targets "Average Inflation" of 2%: ETF Strategies to Play

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On Aug 27, the Federal Reserve announced a new strategy to bring back the United States to full employment level and drive inflation back to healthier levels. Under the new scheme, the U.S. central bank will seek to achieve inflation averaging 2% over time, counterbalancing below-2% periods with higher inflation "for some time."

The new statement of the Fed also pledges to ensure that employment doesn't fall short of a "broad-based and inclusive goal" of maximum employment. The change in the Fed’s tone suggests the its key overnight interest rate, already at rock-bottom levels, will remain so in the medium term as the central bank is striving to drive inflation.

Against this backdrop, below we highlight a few ETF strategies that could be useful for investors in light of the new Fed policy.

Hedge Against Inflation With TIPS

TIPS offers robust real returns during inflationary periods unlike its unprotected peers in the fixed-income world. These securities pay an interest on an inflated-principal amount (principal rises with inflation) and when the securities mature, investors get either the inflation-adjusted principal or the original principal, whichever is greater. As a result, both principal amount and interest payments will keep on increasing with rising consumer prices.

Hence if the Fed tries to boost inflation, products like iShares TIPS Bond ETF (TIP - Free Report) should prevail over regular long-term U.S. treasury ETFs like iShares 20+ Year Treasury Bond ETF (TLT - Free Report) . Notably, TIP lost about 0.4% on Aug 27 while TLT lost 1.7% post Fed comments. Moreover, TIP is gaining after hours while TLT is losing.

Greenback to Gain

First the Fed’s reluctance to control yield curve and now the pledge to boost inflation should boost the U.S. dollar. Benchmark U.S. treasury yield jumped to 0.74% on Aug 27 (up 5 bps from a day earlier) versus 0.56% noted on Aug 3, 2020. Invesco DB US Dollar Index Bullish Fund (UUP - Free Report) was up about 0.1% on Aug 27 and added 0.04% after hours (read: Fed Reluctant On Yield Curve Control Scheme: ETFs to Gain/Lose).

Banks to Advance

The Fed’s latest comments have steepened the yield curve, which in turn benefited banking stocks. The benchmark 10-year U.S. treasury yield gained by five bps to 0.74% on Aug 27 from a day earlier. The yield on two-year treasuries was steady at 0.16%. Overall, the yield curve slightly steepened on Aug 27.

Since banks borrow money at short-term rates and lend capital at long-term rates, steepening of the yield curve bodes well for bank ETFs. SPDR S&P Bank ETF (KBE - Free Report) added about 1.9% on Aug 27.

Real Estate: A Nice Bet

While the prevailing level of low rates is a positive for real estate stocks, pledge for higher inflation would make the segment more compelling. This is because real estates are used to generate rental income, which is likely to grow in an inflationary environment along with rising asset prices. Vanguard Real Estate Index Fund ETF Shares (VNQ - Free Report) added about 1.5% on Aug 27.

Higher Inflation May Cause a Rebound in Value Stocks

Per Investopedia, value stocks normally have strong current cash flows that will slow down over time, while growth stocks have lesser cash flow at the current level but are expected to increase over time. Since an inflationary environment will result in higher rates, growth stocks will be more adversely impacted than value stocks if we discount the future cash flows at expected higher rates.

So, value ETFs like Vanguard S&P 500 Value Index Fund ETF Shares (VOOV - Free Report) (up 0.8% on Aug 27) may beat growth ETFs like Vanguard S&P 500 Growth Index Fund ETF Shares (VOOG - Free Report) (down 0.11% on Aug 27) if average inflation levels pick up in America.

Agriculture Commodities Look Like a Good Short-Term Bet

Inflation normally raises the price of every raw material and agricultural good. In any case, commodities are good hedges against inflation. Moreover, agricultural commodities have been currently witnessing output threats on weather concerns, which make the space even more lucrative for the short term. Invesco DB Agriculture Fund (DBA - Free Report) was up about 1.3% on Aug 27 (read: Tap These ETFs to Play the Strong Momentum in Grains).

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