Here’s an update on the three exchange-traded funds, designed for a rising interest rate scenario.
Top Picks Update
Direxion Daily 20 Plus Year Bear 3 Shares (TMV), Proshares UltraShort Lehman 20 Plus Year Treasury (TBT), and Proshares Short 20 Plus Year Treasury (TBF)
From Sound Advice
In its June 14 meeting, the Federal Reserve raised their Federal funds rate by another quarter point (25 basis points). The Fed said that the economy is strong enough to continue normalizing interest rates from the “Quantitative Easing” programs aimed at forcing interest rates to historically low levels in order to bail the economy out of the 2008-09 melt-down.
During those three rounds of “Quantitative Easing” the Fed purchased $4.5 trillion of Treasury and mortgage-backed securities, which bloated the Fed’s balance sheet by close to 5 times the normal amount. Fed stopped adding to its holdings nearly three years ago with the end of its Quantitative Easing programs. The Fed has since been replacing securities as they matured, keeping the overall portfolio the same size. The Fed has been buying $17.5 billion per month of Treasury bonds and $24 billion per month of mortgage securities.
In May, the Federal Reserve conclusively decided to start a program to “normalize” its balance sheet by shrinking its holdings. This will be accomplished by allowing a fixed dollar amount of holdings to mature each month without reinvesting the proceeds in similar securities. In the June meeting, more details were decided.
The plan is to start reducing the Fed’s current inventory of $2.8 trillion of Treasury bonds, holdings will be reduced by $6 billion per month initially, and gradually to $30 billion per month. To wind down the current holdings of $1.8 trillion of mortgage-backed securities, holdings will be reduced by $4 billion per month, with gradual reductions to $20 billion per month.
The Fed acknowledged that this process will be tantamount to a series of rate hikes. Because the Fed’s holdings have included a preponderance of longer term bonds, the reduction of the Federal Reserve’s bond holdings, will add upward pressure to long-term bond yields.
ETFs for Rising Interest Rates
Our recommended ETFs are designed to benefit from the normalization of interest rates and increase in long-term bond yields from their current historically low levels. They differ in the amount of leverage used. You can choose among them depending on your investment objectives and risk tolerance.
- The Direxion Daily 20 Plus Year Bear 3 Shares (TMV) uses 3:1 leverage.
- The Proshares UltraShort Lehman 20 Plus Year Treasury (TBT) uses 2:1 leverage.
- The Proshares Short 20 Plus Year Treasury (TBF) uses no leverage.
The price action of these ETFs is based on the changes in long-term treasury bonds, as measured by benchmark bond indexes, only in the opposite direction, and then multiplied by the leverage each ETF uses. For example, a decline of say, 1.0 percent in their respective benchmarks will cause TMV to increase by 3.0 percent, TBT by 2.0 percent, and TBF by 1.0 percent. Conversely, an increase in their respective benchmarks will cause these ETFs to drop in the same fashion.
We can project the movements of these ETFs based on any given scenario. We have been using the Federal Reserve’s prediction, which was as good as any. As part of the Federal Reserve’s quarterly Federal Open Market Committee (FOMC) meetings, each of the 17 committee members makes a prediction regarding the future path of interest rates. Those predictions are plotted in the so-called “Dot Plot”.
The most recent Dot Plot was taken at the June 14 meeting. As usual, there was a wide difference in the predictions among this group of informed experts. The median prediction was that the Federal funds rate would be 1.375 percent at the end 2017, 2.125 percent at the end of 2018, and 3.00 percent at the end of 2019. These medians were unchanged from the March 15 meeting.
Assuming long-term Treasury bond yields move in accordance with these target points (to preserve the same yields as today’s real return), long-term Treasury bonds would be yielding 3.49% by the end of 2017, and 4.25% by the end of 2018, and 5.12% by the end of 2019.
Here is what would happen to each ETF:
- TMV would rise from $20.07 to $27.9 by the end of 2017, to $40.30 by the end of 2018, and to $59.70 by the end of 2019
- TBT would rise from $36.48 to $45.45 by the end of 2017, to $58.00 by the end of 2018, and to $75.46 by the end of 2019.
- TBF would rise from $22.76 to $25.41 by the end of 2017, and to $28.72 by the end of 2018, and to $32.74 by the end of 2019.
Gray Cardiff, Sound Advice, www.soundadvice-newsletter.com, 800-825-7007 June 19, 2017