Key Points
- August nonfarm payrolls rose 162,000, far exceeding forecasts, pushing the 2-year Treasury yield to its highest level since January 2025.
- Stronger jobs data raised the odds of a September Fed rate hike above 60%, shifting focus toward the upcoming August CPI report on Sept. 11.
- Investors can position for hawkish or dovish Fed outcomes through IWM, XLF, and TLT, which respond differently to changing interest rate expectations.
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The interest rate whipsaw intensified as August nonfarm payrolls grew by 162,000, well above the consensus estimate of 53,000. The S&P 500 flipped from green to red on the news, and the 2-year Treasury yield rose to 4.416%, its highest reading since January 2025. Once again, the Federal Reserve’s interest rate decision was thrown a curveball, and now the committee must decide whether to hike or remain on hold until December. That decision has different implications for different parts of the economy, and investors can bet on their assumptions through highly liquid exchange-traded funds (ETFs).
What Shifting Expectations Mean for This Cycle
To hike or not to hike, that is the question. Despite political pressure for easier policy, a cut is not the market’s base case. More jobs are obviously better than fewer jobs, but this is another data point pointing to stickier inflation, and the market has repositioned itself to reflect that reality. The CME FedWatch tool showed odds of a September rate hike jumping above 60% in the hours after the jobs data release.
A warming labor market recalibrates the Fed’s decision-making process with roughly two weeks to go until the critical September Federal Open Market Committee (FOMC) meeting. July PCE was still uncomfortably high at 3.7%, and three FOMC members dissented in favor of hiking at the July meeting. A strong labor market report puts the dual mandate’s focus squarely back on inflation, which remains supply-induced. The August jobs report simply kicked the catalyst energy to the August Consumer Price Index (CPI) release on the morning of Sept. 11.
3 ETFs for a Changing Rate Environment
The September rate decision remains murky, and CPI may do little to crystalize the waters. But long-end rates continue to move upward, and the average 30-year mortgage rate is approaching its 2025 high. A hawkish or dovish Fed would impact the economy in different ways, and these three ETFs provide options to play the various outcomes.
Russell 2000: Where Rate Signals Collide
The iShares Russell 2000 ETF (NYSEARCA: IWM) is one of the most cost-effective ways to gain exposure to the vast ecosystem of small and mid-cap stocks on U.S. exchanges. It charges a small 0.19% expense ratio and has amassed more than $80 billion in assets under management (AUM). Over 90% of the fund’s holdings are U.S.-based, and no stock makes up more than 0.38% of the total portfolio.
The Russell 2000 index is an interesting study in rate signals. The index is heavily weighted toward domestic companies, so strong U.S. job growth generally leads to positive earnings growth in these stocks. But these companies are also the most sensitive to high rates since their debt is typically floating-rate or closer to maturity than large-cap debt. A trend shift in IWM will likely offer clues about which factor is carrying more weight in the small-cap environment.
The Financial Sector: Getting the Best of Both Worlds
There’s no double-edged sword in the finance world when it comes to rates and job growth. When rates rise, banks get better yields on their bond holdings and higher net interest margins on the loans they offer. And if employment strengthens, consumers have more access to credit, and banks can take on higher-quality credit. A high-rate environment with a strong labor market is the Goldilocks scenario for banks, which is why so many stocks in this space have hit new all-time highs this year.
The Financial Select Sector SPDR ETF (NYSEARCA: XLF) is the cheapest way to access the financial sector with a 0.08% expense ratio and more than $55 billion in AUM. The fund's top 25 holdings account for more than 77% of the fund. The largest holdings include large-cap financial firms such as JPMorgan Chase & Co. (NYSE: JPM), Berkshire Hathaway Inc. (NYSE: BRK.B), and Visa Inc. (NYSE: V).
Long-dated Bonds: Duration Risk No Longer Provides a Hedge
Our final ETF is the iShares 20+ Year Treasury Bond ETF (NASDAQ: TLT), which has a 0.15% expense ratio and an average duration of 16 to 17 years in its nearly $47 billion bond portfolio. A hawkish Fed may not affect a fund with maturities this far out, but TLT’s role as an equity hedge may not last if the drawdown is inflation-driven rather than growth-driven.
Strong job growth argues against easing, and higher rates on long-dated bonds mean the price of currently issued bonds drops. Since Treasuries are sold at a fixed rate, older issues must sell at a lower price to compete with newer ones with higher coupon rates. TLT sells its bonds once they reach less than 20 years to maturity and replaces them with newer, longer-dated bonds. In a high-rate environment, TLT must sell its older bonds and replace them with more expensive ones, creating a mismatch that lowers the value of its holdings.
One important caveat: TLT’s price is influenced by the long end of the curve, and a Fed that raises rates could restore credibility and result in lower long-term borrowing costs (i.e., 30-year Treasury yields drop). Additionally, a hold could pressure inflation expectations and push rates even higher at the upper end, so TLT’s position is very tumultuous ahead of the FOMC meeting.
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