With a lot of uncertainty over interest rates still shadowing the markets, exchange traded fund investors should prepare for multiple outcomes.
Investors can plan for the three most probable outcomes of a Federal Reserve tightening, along with the possible ETF plays.
For starters, the yield curve could tighten with 3-year and 5-year rates moving up faster than long-term yields, which would indicate a healthy economy that is expanding without surging inflation, writes Mark Eicker, lead portfolio manager and CIO at Sterling Global Strategies, for Forbes.
In a healthy exit from the Fed’s loose policies, investors would stay long U.S. equities, like the SPDR S&P 500 ETF (NYSEArca: SPY), to capitalize on further growth and a non-hedged iShares MSCI EAFE ETF (NYSEArca: EFA) once overseas rates begin to rise. Eicker also suggests mid-term duration bond ETFs for the fixed-income portfolio. The Guggenheim BulletShares 2024 Corporate Bond ETF (NYSEArca: BSCO) provides a target-date maturity bond portfolio of corporate debt exposure. Additionally, for municipal tax-exempt income, the SPDR Nuveen Barclays Municipal Bond ETF (NYSEArca: TFI) comes with a 7.48 year duration. [Muni Bond ETFs Look Attractive After Pullback]
If the yield curve steepens, every fixed-income asset will see higher rates but longer dated bonds will see yields rise the most, suggesting that the economy is quickly heating up. We would also experience a surge in inflation. The iShares TIPS Bond ETF (NYSEArca: TIP) would help diminish the negative effects of rising inflationary pressures, and something like the iShares Floating Rate Bond ETF (NYSEArca: FLOT), which has an effective duration of 0.2 years, will help hedge against further rate risk. [Floating Rate ETFs for Rising Rates Protection]
Lastly, short-term rates could rise while long-term yields fall, which could point to a slowing U.S. economy as corporate borrowing costs rise. Consequently, high-yield options and high-quality long-duration bonds could outperform. For example, the Vanguard REIT ETF (NYSEArca: VNQ) provides broad exposure to yield-generating real estate investment trusts – VNQ has a 3.5% 12-monthy yield. Moreover, the iShares 20+ Year Treasury Bond ETF (NYSEArca: TLT) provides exposure to long-term U.S. debt, which would benefit the most as long-term bond yields fall.
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Max Chen contributed to this article.
Full disclosure: Tom Lydon’s clients own shares of SPY.