Inflation-driven instability in US sectoral betas

Abstract

This study specifies and estimates the monthly beta coefficients as a function of annualized inflation for all sectoral exchange-traded funds (ETFs) in the USA during January 1999 to February 2024. We ensure consistency in definitions and prevent constituent overlap by using SPDR sector ETFs, which have the longest return history. The findings indicate that when inflation moves out of the 1–5% range, particularly beyond 4–5% on the upside, the functional betas across all sectors exhibit nonsensical behavior and become extremely unreliable. This behavior highlights the vulnerability of all sectoral ETFs to high inflation. Investment strategists should note that the Fed’s 2% inflation target is crucial for ensuring beta’s reliability as a systemic risk measure across all sectors. This finding recently highlights the need for the Fed to control inflation before cutting rates to maintain financial market stability.