With the Federal Reserve signaling that it is on pace to shrink its balance sheets and raise interest rates, fixed-income investors may think about alternative investment options to hedge against rate risks.
After over a decade of a zero-interest-rate policy, the Fed has issued two quarter-percent rate hikes and brought the federal funds rate up to 1% for the first time since 2008.
The Federal Open Market Committee, or FOMC, has also indicated that the upward rate trend will likely continue, with some officials in recent weeks supporting the notion that the economy will be strong enough to warrant two more quarter-percentage-point rate hikes this year. Fed officials also moved toward a consensus on a proposal to start gradually shrinking its $4.5 trillion in holdings of Treasury and mortgage securities later this year.
Supporting the rate outlook, the U.S. is seeing increased economic growth, rising inflation and greater employment numbers. Inflation briefly exceeded the Fed’s 2% target in February but dipped in March to 1.8%. Meanwhile, the unemployment rate fell to 4.4% or at the bottom range of officials’ expectations.
Market observers and investors will have to watch the next Fed meeting in June 13 to 14 for further clarity on the central bank’s monetary policy. Traders in futures markets already placed about an 80% probability on a Fed rate hike by June.
“The growing pace of rate increases is particularly important to bond traders who, as interest rates rise, will see a decrease in yield and subsequent sale value of corporate and treasury bonds,” according to a Direxion note. “As rates have been at all-time lows since the 2008 financial crisis, the bond market has experienced volatility in recent months in response to both rising rates as well as the increased value of securities that thrive on economic and market growth like stocks.”
With the markets keeping a close watch on Fed movements, particularly the FOMC meetings, bond ETF traders have tried to hedge risks or capitalize on market turns through leveraged and inverse Treasury bond ETFs.
For example, the Direxion Daily 7-10 Year Treasury Bull 3x Shares ETF (NYSEArca: TYD) and Direxion 7-10 year Treasury Bear 3x (NYSEArca: TYO) helped provide a long and short leveraged 300% daily stance on Treasury debt securities with seven to 10 year maturity.
Similarly, the Direxion Daily 20+ Year Treasury Bull 3x Shares ETF (NYSEArca: TMF) and Direxion Daily 20+ Year Treasury Bear 3x Shares ETF (NYSEArca: TMV), which tracks the 300% long and short daily performance of the NYSE 20 Year Plus Treasury Bond Index, respectively, have been popular ways to more aggressive exposure to the turns in the Treasury market.
Less aggressive fixed-income investors may also hedge against the Federal Reserve interest rate hike through simple inverse or short Treasury bond ETFs, such as the Direxion Daily 7-10 Year Treasury Bear 1x Shares (NYSEArca: TYNS) or Direxion Daily 20+ Year Treasury Bear 1x Shares (NYSEArca: TYBS).
“While the current ecosystem of rising interest rates and steady economic activity may make bonds less appealing to some investors, rising rates mean that, long-term, bond yields will tend to rise,” according to Direxion. “That may not mean much in the short-term interest rate environment, but tactical managers should consider those yields when weighing the role of bonds in their own portfolios.”