Though the fixed income world, in particular Treasury bonds, gathered some steam starting this year, these are faltering again thanks to the Fed latest comments. The Fed, which has committed to keep short-term interest rates at a near zero level, signaled a rate hike sooner than expected (read: 3 Bond ETFs Kick Off 2014 with Strong Inflows).
This is especially true as Janet Yellen withdrew the unemployment rate threshold of 6.5% before raising rates. Now, the Fed views increase in short-term rates six months after the current monthly bond purchases program ends, which is expected this fall. As such, short-term interest rates are expected to move up by the middle of 2015.
This concern has led to a broad sell-off in the Treasury bond market, resulting in spiking yields. Unlike last year, short-term Treasury bonds are the worst hit this time while intermediate and long-term Treasury bonds are trending lower.
This is because the short end of the yield curve is rising faster than the long end, and the spread between both the two yields is narrowing. The spread between the 2-year and 30-year yields tightened to the lowest since July, indicating that the yield curve is flattening.
This trend is likely to continue in the coming months, suggesting investors might want to avoid riding the yield curve or take an inverse position. This could be easily done through the only option in the broad bond ETF space – iPath US Treasury Flattener ETN (FLAT - ETF report).
FLAT in Focus
This product provides inverse (or opposite) exposure to the Barclays US Treasury 2Y/10Y Yield Curve Index, which delivers returns from the steepening of the yield curve through a notional rolling investment in U.S. Treasury note futures contracts (read: 3 Treasury Bond ETFs to Play Rising Short Term Yields).
The index takes a weighted long position in 2-year Treasury futures contracts and a weighted short position in 10-year Treasury futures contracts. It generally rises when the yield curve steepens and falls when it is flattening. As such, investors could make smart profits from the flattening of the yield curve through the ETN thanks to its inverse relation with the index.
However, investors should note that FLAT is expensive, charging 0.75% in fees and expenses, and has higher trading cost thanks to its illiquid nature. The product is unpopular too as it has amassed just $4.7 million in its asset base.
The note gained nearly 3.5% over the trailing three months and has clearly outpaced the broad U.S. market fund (SPY - ETF report) and the ultra-popular short-term bond (BSV - ETF report) by a wide margin. This trend is likely to continue given sooner-than-expected interest rate hikes as well as positive technical signals (see: all the Government Bond ETFs here).
Although the note hasn’t broken out of its near-term range, its short-term moving averages (9-Day and 50-Day SMA) is now comfortably above the longer-term 200-Day SMA, suggesting continued bullishness for this ETN.
Meanwhile, the product’s RSI is below 60, suggesting that the note isn’t too overbought, and that it still has some more room to run. This is further confirmed by an upswing in the Parabolic SAR, although this figure should definitely be monitored closely.
Given that the increase in interest rates could come sometime in the middle of 2015, the Flattener ETN makes for a compelling choice for investors seeking to take advantage of the flattening yield curve.
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