Despite the ongoing volatility, the Federal Reserve has not shifted away from an interest rate tightening cycle. Consequently, investors should understand the potential effects or rising rates on the markets and incorporate alternative exchange traded fund strategies to adapt to the changes.
On the recent webcast, Positioning Portfolios in a Rising Rate Environment, Joe Benevento, CIO for Americans and Co-Head of Global Fixed Income at Deutsche Asset Management, projected that the tightening Fed monetary policy will only cause rates to rise gradually.
The gradual rate hike projections are based on Deutsche Asset Management’s below consensus view of U.S. GDP expectations and the consumer price inflation outlook for the year head.
Meanwhile, Benevento pointed out that while the U.S. is beginning to hike rates, global monetary policy remains loose, notably from the Bank of Japan and European Central Bank.
Consequently, with the diverging Fed and foreign central policies, we can expect the U.S. dollar to continue appreciating against overseas currencies. For instance, Sebastien Galy, FX Strategist at Deutsche Bank, forecasts the euro currency to potentially weaken below parity to the USD this year and continue to depreciate next year before bouncing back in 2018. Galy, though, anticipates the Japanese yen to weaken against the greenback in 2016 but begin to strengthen after this year’s pullback. Deutsche largely projects the USD to strengthen against G10 country currencies this year.
The USD is currently in a large uptrend, and Galy believes the greenback is a little beyond two-thirds the way through its current cycle, so we may continue to see the dollar strengthen against foreign currencies ahead. Jack Fowler, V.P of Global Client Group for Deutsche Asset Management, also pointed out that USD cycles typically last eight years, with downward cycles showing dollar depreciation up to 50 percentage points – we are only in our fourth year of the current bull cycle, with the USD up 29%.
If investors wish to capture overseas equity exposure but are wary of currency risks, especially in a strengthening USD environment, there are a number of currency-hedged international stock ETFs available.
“Investors have paid closer attention to currencies over the past few years because of the material impact currency exposure has had on international equity investments.,”Jack Fowler, V.P of Global Client Group for Deutsche Asset Management, said “Overall, hedged indices seek to give investors the same equity exposure of a local investor and strip out this additional currency risk.”
The Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEArca: DBEF), which takes the currency hedged exposure of developed Europe, Australasia, Far East countries, has been a popular broad international play. DBEF was the second most sought after ETF of 2015. DeAWM also offers the Deutsche X-trackers MSCI EMU Hedged Equity ETF (NYSEArca: DBEZ) for hedged Eurozone exposure and the Deutsche X-trackers MSCI Japan Hedged Equity ETF (NYSEArca: DBJP) for a hedged Japanese equity position.
Moreover, the Fed tightening will also cause yields to rise or bond prices to fall. Advisors and investors have begun to hedge against rising rates by shifting down the yield curve to lower duration bond funds. On the other hand, Chuck Self, CIO and COO of iSectors LLC, suggests investors may turn to innovative low duration bond portfolios as a way to diversify risks. For instance, people can look to hedged bond investments.
With yields ticking higher, bond investors can utilize rate-hedged bond ETFs to generate income and help better maintain their principle, including the Deutsche X-trackers Investment Grade Bond – Interest Rate Hedged ETF (NYSEArca: IGIH), Deutsche X-trackers High Yield Corporate Bond – Interest Rate Hedged ETF(NYSEArca: HYIH) and Deutsche X-trackers Emerging Markets Bond – Interest Rate Hedged ETF (NYSEArca: EMIH).
IGIH tracks investment-grade corporate bonds, HYIH includes a group of speculative-grade junk bonds and EMIH follows U.S.-dollar-denominated emerging market bonds. These options try to mitigate interest rate sensitivity across the yield curve in a rising rate environment by taking short positions in U.S. Treasury futures. Through their short positions, the hedged bond ETFs have a modified duration of about zero years – duration is a measure of a bond fund’s sensitivity to changes in interest rates. Consequently, since these bond ETFs essentially have a zero duration, a rising interest rate would not negatively affect the investments.
Financial advisors who are interested in learning more about alternative ETF strategies for a rising rate environment can listen to the webcast here on demand.