Using ETFs to Profit From Rising Interest Rates

by: Bruce Vanderveen

Inflationary alarms -- increasingly loud -- are sounding worldwide. Europe, Canada, Great Britain, emerging markets such as China, India and Brazil have, or are contemplating, raising interest rates.

My recent article on crisis investing noted 4 sectors you should be in: oil, real estate, gold, and inverse interest rate ETFs. Here we will look at the fourth -- and most speculative -- sector: interest rate sensitive ETFs.

Walking the Edge of the Precipice

For now, the U.S. continues to pursue an easy money policy. How long this can continue though is the subject of much debate. Despite QE2, interest rates have risen steadily from last November's lows.

If the Fed stops buying Treasury bonds in June (when QE2 ends) will rates jump as this major buyer leaves the market? On the other hand, if some form of QE3 is announced, will rates jump as they did when QE2 was announced. This looks like a "can't win" scenario.

More ominously: "flight to safety" events such as the current crisis in North Africa now seem to be sending money into precious metals -- not U.S. Treasuries.

Perhaps now is the time to look at inverse interest rate ETFs. First, though, let's look at a much more conservative investment: the inflation adjusted U.S. Treasury bond ETF.

Inflation Protected U.S. Treasury Bonds.

Barclay's TIPS Bond ETF (NYSEARCA:TIP), inflation protected U.S. Treasury bonds, is an ETF combining fixed income and inflation protection. One criticism is: This ETF is a government product, using an outdated inflation gauge, and may payoff in depreciated U.S. dollars.

Nonetheless, TIP provides some of the security bond investors crave plus built in inflation protection. This is probably one of the most conservative inflation hedges you can find.

Inverse Interest Rate ETFs

You can directly benefit from rising U.S. interest rates with inverse ETFs: Pro Shares Short 20+ Year Treasury (NYSEARCA:TBF) and Pro Shares UltraShort 20+ Year Treasury (NYSEARCA:TBT).

If you feel, as I do, that rates will inevitably rise, consider these two. TBT is "ultrashort" meaning it is leveraged. You get twice the profit potential but also twice the "time decay" while holding it (See Tracking Errors and Other Cautions, below).

Currency ETFs

Forex trading is extremely risky. Currency ETFs are only somewhat safer. Today's trend (your friend?) is commodity driven inflation. Commodity based currency ETFs such as the Canadian dollar (NYSEARCA:FXC), the Australian dollar (NYSEARCA:FXA) and the Brazilian real (NYSEARCA:BZF) should continue to do well while the U.S. dollar (NYSEARCA:UUP) will continue dropping if current trends continue. Personally, I would rather just hold equities with commodity assets.

Don't like the risk of a single emerging market currency? Look at Wisdom Tree Emerging Currency ETF (NYSEARCA:CEW).

Safety currencies -- strong in recessionary times -- have in the past been the U.S. dollar (UUP), the Japanese yen (NYSEARCA:FXY) and the Swiss franc (NYSEARCA:FXF). Large sovereign debts in Japan and the U.S. may cause the first two to lose their safe haven status in coming years though.

Tracking Errors and Other Cautions

Costs can degrade ETF values over time (time decay). Know what you are getting into. One major cost is tracking error (the difference between the daily return of the ETF and the target return). Seeking Alpha lists ETF tracking errors and other stats. Just search the ETF symbol -- tracking error appears under ETF Stats. Tracking errors arise from contango, expense ratios, cash balances, fees etc. See here for more detailed information.

Here are tracking errors (per SA) for the above mentioned ETFs: TIP: 0 .13%, TBF: 0.28%, TBT: 0.55 FXA: 0.51%, FXC: 0.36%, and BZF: 0.45%. CEW's tracking error was unavailable on SA.

Of course, you would never want to put all, or even a large portion, of your money into these ETFs. It is a paper, often futures or swap based, instrument, with all the attendant risks. A surprise central bank move could quickly reverse your fortunes.


Inflationary trends are currently putting upward pressure on interest rates worldwide. One way to profit is using ETFs. However, keep in mind the holding costs (tracking error etc.) and speculative nature of most of these instruments. Interest rates and inflationary trends must be watched carefully.

QE2 ends this June. Whether or not the Fed continues QE in some form then will strongly affect the ETFs above. The North African/Middle Eastern crisis . . . Congressional debt debates . . . QE uncertainty -- all will keep things on edge for the next several months.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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