The Federal Reserve meets on Dec. 13-14, and bond traders are pricing in the first interest rate hike of 2016. In fact, the Fed funds futures market indicates a rate hike of 25 basis points is basically a sure thing.
When speculation increases that the Fed is nearing an interest rate hike, investors’ behavior is usually predictable. Typically, investors shy away from longer-dated bonds (as they should) and rate-sensitive sectors, such consumer staples and utilities, in favor of lower-duration fixed-income options and cyclical sectors, including financials and technology. There are even some dividend exchange-traded funds (ETFs) designed to thrive as borrowing costs climb.
In other words, the standard rising-rates playbook usually focuses on domestic investments. Seems logical. After all, the Fed is the U.S. central bank, but against the backdrop of higher U.S. interest rates and hawkish Fed action, investors should not eschew international stocks.
That is particularly true because of a common occurrence around the time that higher rate expectations start climbing: The dollar rises, too. A strong dollar means foreign currencies are declining, potentially boosting earnings for international stocks that derive significant portions of their sales in the U.S.
Good news: The U.S. Dollar Index, which tracks the greenback against a basket of developed market currencies, is higher by more than 3% over the past month. Prolonged dollar strength courtesy of the Fed could be a boon for the following international ETFs.
International ETFs to Buy: WisdomTree Japan Hedged Equity Fund (DXJ)
Expense ratio: 0.48% per year, or $48 on a $10,000 investment.
The WisdomTree Japan Hedged Equity Fund (NYSEARCA:DXJ) is one international ETF that, by virtue of it being a currency hedged fund, is intimately levered to the dollar’s fortunes and, as a result, Fed policy. Price action confirms as much.
Over the past month, 10-year Treasury yields are up about 31% while the yen has tumbled more than 8% against the dollar. That translates to DXJ being a stellar performer among international ETFs over that span with a gain of over 11%.
Past performance is never a guarantee of future returns, but previous annual returns underscore DXJ’s leverage to the strong dollar.
In 2014 and 2015, the U.S. Dollar Index posted an average annual return of almost 9%. Not coincidentally, there was plenty of interest rate hike speculation in 2014 and an actual rate hike last December. In those two years, DXJ post average annual returns of nearly 8%, making it one of the better non-leveraged international ETFs over that period.
With the dollar soaring in anticipation of the Fed’s first rate hike of 2016, investors are being reminded of the advantages of international ETFs that are currency hedged. Over the past three years, DXJ has delivered better than double the returns offered by the iShares MSCI Japan ETF (NYSEARCA:EWJ).
International ETFs to Buy: Vanguard Total International Bond ETF (BNDX)
Expense ratio: 0.15%
Just because Treasury yields are rising does not mean investors need to ditch bonds. International ETFs offer some compelling options for investors looking to maintain some fixed-income exposure in the face of Fed rate hikes, and the Vanguard Total International Bond ETF (NASDAQ:BNDX) is one of those choices.
Perhaps by virtue of its size (just $64.6 million in assets as of Oct. 31), BNDX is overlooked relative to other Vanguard ETFs, but BNDX maintains at least one Vanguard tradition: Low fees. This international ETF charges just 0.15% per year, which is 85% lower than the average of rival funds, according to Vanguard data.
BNDX, which holds nearly 4,160 bonds, has an average duration of almost eight years, but this is an international ETF chock full of countries with monetary policies that are diverging from that of the Fed. For example, Japan, France and Germany combine for about 43% of BNDX’s weight and there is essentially no chance Japan or the Eurozone will raise interest rates anytime soon.
On that note, BNDX is also a play on dollar strength because this international ETF is also currency hedged. Credit quality is not a concern with BNDX as about 80% of its holdings are rated AAA, AA or A.
International ETFs to Buy: Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF)
Expense ratio: 0.35%
The Deutsche X-trackers MSCI EAFE Hedged Equity ETF (NYSEARCA:DBEF) is one of the currency-hedged answers to the traditional batch of international ETFs tracking the widely followed MSCI EAFE Index. That means this is an ideal ETF for those investors looking for exposure to international stocks without the risks of an individual country bet.
As a currency-hedged answer to the MSCI EAFE Index, DBEF delivers multi-country exposure, meaning investors will want to see the dollar rally against myriad foreign currencies, so keep an eye on the U.S. Dollar Index and the Fed.
DBEF can hold international stocks from Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom, according to its issuer.
Japan, Great Britain, France, Germany and Switzerland combine for nearly two-thirds of DBEF’s geographic weight. Translation: Four of those are negative-interest-rate countries and the Bank of England is unlikely to move in unison with the Fed in terms of a rate hike, indicating DBEF could be an ideal play for multiple rate hikes in 2017.
At the time of this writing, Todd Shriber did now own any of the aforementioned securities.