US Treasury ETFs trend lower in anticipation of interest rate hikes

Mar 7th, 2017 | By | Category: Fixed Income

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Tough talk from the US Federal Reserve and an anticipated hike in interest rates as soon as next week have seen 10-year US Treasury yields moving sharply higher to 2.5%, its highest point thus far in 2017, with fixed income ETFs dropping as a result.

US Treasury ETFs trend lower in anticipation of interest rate hikes

Pricing in the Federal Funds Futures Market is implying a probability of over 80% for an interest rate increase by the Federal Reserve in March.

The 10-year yield recently moved above its 50-day moving average (potentially signalling the beginning of a strong upwards trend according to some technical analysts), and the policy-sensitive two-year yield has also climbed to 1.3% – its highest level since 2009.

Bond ETFs tracking US Treasuries accordingly fell due to the inverse relationship between bond prices and yields. The Vanguard USD Treasury Bond UCITS ETF (LON: VDTY) lost 0.98% in USD terms from 27 February to 3 March.

ETFs that track longer-dated debt, which is more sensitive to yield movements, suffered larger losses – the iShares USD Treasury Bond 20+ Year UCITS ETF (LON: IDTL) fell 2.3% over the same period.

The jump in yields has also been attributed to reduced foreign buying of Treasury debt, particularly from Japan, and investor concerns that the US central bank may reduce its large balance sheet.

Market odds of an interest rate hike in March soared to 80% last Tuesday. A closely watched measure of inflation, the Personal Consumption Expenditures Index, grew at an annual rate of 1.9% in January, the closest it has been to the Fed’s 2% target since 2012. A strong 227,000 jobs were added in January and initial jobless claims – layoffs – are at four-decade lows.

William Dudley, head of the New York Federal Reserve, said in an interview with CNN and reported by the Financial Times, that the institution did not need to see Republican tax reforms and other policies before acting, and the reasons to hike rates had become “a lot more compelling”.

“It seems to me that most of the data we’ve seen over the last couple months is very much consistent with the economy continuing to grow at an above-trend pace, job gains remain pretty sturdy, inflation has actually drifted up a little bit as energy prices have increased,” he said.

The Fed meets on 14 and 15 March, and later in May and June.

Analysts say that May might be tricky due to the impending French election. If the Fed leaves rates alone until June, six months will have passed without a rate hike despite surprisingly strong economic data. At their last meeting, a number of officials said they wanted to act “fairly soon” on rates.

A hike in March means officials would act before seeing Mr Trump’s budget.

Three hikes are predicted for 2017. Investors looking to adopt a portfolio of US Treasuries, with a blend of shorter and longer-dated securities, may wish to consider the following low-cost ETF from SPDR ETFs.

The SPDR Barclays US Treasury Bond UCITS ETF (LON: TRSY) costs 0.15% and has three quarters of its exposure in bonds that expire between one and seven years’ time, with 11.4% in 7-10 year bonds and 14.5% in bonds that mature between 10 and 20 years’ time. Overall it has an effective duration of 5.69 years.

For those who want to better mitigate the impact of rising rates this year by seeking lower duration portfolios, there are several passive funds that focus on shorter-dated Treasuries and hence offer a lower duration profile.

The cheapest is the $73m SPDR Barclays 1-3 Year US Treasury Bond UCITS ETF (LON: TRS3) for 0.15% fees. It has an effective duration of 1.9 years and has edged up 0.11% over one year and just 0.09% year to date in USD terms.

Another option is the $72m iShares USD Treasury Bond 1-3yr UCITS ETF (LON: CBU3) which costs 0.20%. It is up 0.19% and 0.05% respectively. It also has an effective duration of 1.9 years.

There are also inverse and leveraged funds that can be used for tactical portfolio positioning to hedge portfolios against losses during rate increases or, for more risk-seeking investors, to strategically position the portfolio to profit from a rate increase.

Two examples are from Boost and Lyxor.

The Boost US Treasuries 10Y 5X Short Daily ETP ($) (BORSA ITALIANA: 5TYS) may suit more risk-seeking investors as the ETP provides five times the inverse daily performance of the US Treasury Note 10Y Rolling Future Index, which tracks front-month 10-Year US Treasury Note futures, plus the interest revenue earned on the collateralised amount. Its annual management fee is 0.50%.

The Lyxor Daily Double Short 10Y US Treasury UCITS ETF (LON: DSUS) costs 0.20%. As Lyxor notes, it aims to reflect a leveraged inverse exposure to the daily performance of the United States Long Term Bond Market while avoiding the costs linked to the use of cash instruments.

Investors should note that due to the daily compounding effects of these products, investors may suffer significantly amplified losses over time. As such these ETPs are recommended as short-term tactical holdings for more experienced investors.

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