In a statement to the House Financial Services Committee, U.S. Federal Reserve chair Janet Yellen made her intentions clear regarding the heavily anticipated issue of interest rates.
The economy, according to her assessment, is “performing well” and “it could be appropriate” to lift interest rates before the end of the year, when members of the Federal Reserve will convene in mid-December.
Weighing in on the interest rates drama was a number of prominent investment analyst firms providing their forecasts. Renowned futures trading expert CME Group places the odds of Janet Yellen shutting the monetary spigot at 47%, whereas Bloomberg‘s research on futures contract price changes suggests a coin-toss probability.
In addition, a survey of economists conducted by The Wall Street Journal indicated that 64% of financial experts believe that the final month of the year will culminate in a lifting of interest rates — something that hasn’t occurred for nearly a decade.
Janet Yellen and the Federal Reserve’s commentaries over the past two years have echoed an equally opaque motif — interest rates will rise if and when the economy improves. So far, the results have been anything short of conclusive.
Although unemployment has statistically trended southwards, average wages adjusted for inflation have gone nowhere. Real estate, the other bedrock that the Federal Reserve uses to gauge economic health, flat-lined recently, with new home sales contracts for September falling 15% below forecast.
Ultimately, however, the robust recovery in the Dow Jones Industrial Average and the major indices provides a perfect cover story for the Federal Reserve to shift away from their dovish strategies. After all, interest rates can’t stay artificially suppressed indefinitely.
Because of radical changes that will come our way at some point or another, investors should be prepared to hedge their bets against possible volatility in the markets. Here are three exchange-traded funds that should do well as the Federal Reserve gradually embarks on a new chapter of monetary policy.
PowerShares Senior Loan ETF
Although Wall Street analysts are largely divided as to the timing of the Federal Reserve’s policy on interest rates, the markets themselves are decidedly less ambiguous.
The yield for 10-year U.S. Treasuries — often considered the benchmark for interest rates — has moved up almost 7% year-to-date, while yields for 30-year Treasuries jumped 12% YTD. Whether Janet Yellen makes the call this year or next, the markets are slowly coping with inevitability.
In light of these changes, exposure to senior loans — or private debt instruments for companies that are rated below investment-grade — can turn out to be a shrewd maneuver. True to its name, senior loans take priority over other forms of debt or equity in case of a credit crisis, thus providing a certain threshold of protection for investors.
One of the most convenient ways to utilize this instrument is the PowerShares Senior Loan ETF (BKLN), which presently offers a relatively hefty 4% dividend yield for the trailing 12 months.
Aside from prioritization in liquidation proceedings, one of the primary advantages of the BKLN fund is reduced risk from changes in interest rates. Typically, senior loans have rates that are pegged above a key benchmark, and are reset on a quarterly basis. Therefore, even if interest rates rise, the value of the senior loan instrument should not change by much.
From an investor’s perspective, this translates into the BKLN providing consistent passive income in an uncertain environment. The major caveat is the exchange of risk towards interest rates and the credit risk associated with unfavorable companies. Even though senior loans are senior, there are no guarantees of how much money can be recouped if things go awry.
Direxion Daily Financial Bear 3X ETF
Taking a step on the extremely speculative side of things is the Direxion Daily Financial Bear 3x ETF (FAZ), which is a leveraged inverse ETF that tracks the performance of the Russell 1000 Financial Services Index. The FAZ essentially creates a short position by investing in a combination of exotic financial instruments, such as options, futures contracts, and swap agreements.
A word of caution: Leveraged funds like the FAZ substantially amplify risk in addition to rewards. They should be used cautiously, only with speculative money, and you should monitor any positions closely. A 3x leveraged fund like this comes with the potential to make (or lose) money at three times the rate of the index it tracks.
Typically, as interest rates rise, investors seek the safe-haven shelter of banking stocks. As rates move higher, loan services divisions should in theory be more profitable. However, the present situation is atypical of previous economic cycles.
Despite the Federal Reserve’s massive quantitative easing program, evidence shows that the labor market has neither improved on a quantifiable nor a qualitative basis. With such profound weakness in America’s middle class, that’s one major chunk of revenue that the financial sector won’t be able to leverage effectively.
In addition, many banking stocks are expensive based on price-to-earnings ratios. This may suggest that a near-term pullback is in order, particularly since the big banks’ share prices have failed to challenge prior highs after recovering strongly from August’s broad market correction. Tepid trends in revenue and earnings growth only fuels the bearish perspective.
Though the FAZ does have the potential to explode skyward — the fund gained a remarkable 41% in the week following August 18 — we have to remember that it dropped 96% of value in the markets since late August 2010.
The shifting economic transition engineered by Janet Yellen could very well turn things around for the FAZ, but careful exposure is the key to success for leveraged funds.
ProShares UltraShort Real Estate ETF
Another name to add to the list of high-risk, high-reward investments that should do well under rising interest rates is the ProShares UltraShort Real Estate ETF (SRS). The SRS inversely tracks the performance of the Dow Jones U.S. Real Estate Index. Due to its two-times leverage, capital risk is somewhat mitigated as compared to the FAZ (though it still moves at double the speed of the index it tracks).
As complicated as some of the internal mechanisms of inverse ETFs can be, the bear argument for real estate is very straightforward. As interest rates increase, it tends to take mortgage rates along for the ride. Even the mere possibility of a hawkish Federal Reserve sent mortgage rates soaring.
The average for the 30-year fixed-rate leaped 11-basis points to 3.87%, registering the biggest one-week percentage move since this past June. Other benchmark rates, including the 15-year fixed and the five-year adjustable rate mortgage, saw significant increases.
On the flipside of the coin, demand for loan applications declined by 0.8%, while indicators measuring refinance and purchasing activity both dropped by 1%. Should this bearish trend continue — and judging by Janet Yellen’s presumed itchy trigger finger, it will — the SRS fund might just see a hearty reversal in its fortunes.
As of this writing, Josh Enomoto did not hold a position in any of the aforementioned securities.
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