The possibility of a rate hike in the Fed's March policy meeting, which is in two weeks, increased following comments from a few officials, including Dudley, Williams, Kaplan and Harker. If this was not enough, Fed Governor Lael Brainard - who was a strong proponent of easy money policy before - also signaled a sooner-than-expected tightening, saying "it will likely be appropriate soon to remove additional accommodation."
With this, the odds of a March rate hike increased to 69% as per CME, while some other market gauges claim that it is as high as 80%. Stabilization in the global economy with the U.S. staging a steady recovery, a solid labor market and a considerable pickup in inflation led to the hawkish tone of the Fed officials.
The Fed raised benchmark interest rates by a modest 25 bps to 0.50-0.75% in December 2016 for the second time after almost a decade, attesting to the U.S. economy's growth momentum and the labor market's well-being, though both have room for improvement. The Fed then forecast three rate hikes in 2017.
Why Chances Are Strong for a March Hike
The U.S. consumer inflation rate picked up pace for six months in a row to reach the highest level in January since March 2012. Existing home sales scaled a 10-year high, and the otherwise struggling retail sector staged a solid comeback in January.
Retail sales in January grew 0.4% sequentially after an upwardly revised 1% rise in December, and came ahead of market expectations of a 0.1% expansion.
Added to these upbeat data points, a fear of a bubble is also building up in the stock market, thanks to cheap dollar inflows. So, the Fed will definitely act in a way that a bubble is not formed due to a prolonged easy money era or that the economy does not run into a recession following a sudden rise in rates.
Impact on the Fixed-Income Market
The latest hawkish comments from Fed officials took the yield on 10-year U.S. Treasury note to 2.49% on March 2, 2017, from 2.36% on February 28. A rising interest rate scenario is highly unfavorable for bonds, as yields are negatively related to prices. Quite expectedly, bonds had a bloodbath lately.
But even in this fixed-income rout, some products stood out, thanks to their smart investment objective. Below we highlight a few:
iShares 0-5 Year High Yield Corporate Bond ETF (NYSEARCA:SHYG)
The fund follows the Markit iBoxx USD Liquid High Yield 0-5 Index for exposure to liquid high yield corporate bonds maturing between zero and five years. With the fund's effective duration being 2.25 years, it carries relatively less interest rate risk, while at the same time offers 5.51% yields annually. The fund charges 30 bps in fees.
ProShares Investment Grade-Interest Rate Hedged ETF (BATS:IGHG)
The fund holds investment grade bonds in its portfolio, and looks to alleviate rising rate worries through an interest rate hedge approach using U.S. Treasury futures. Since the fund targets a duration of zero, this could be an intriguing play right now. IGHG charges 30 bps in fees. Its weighted average maturity is 3.94%.
Janus Short Duration Income ETF (NYSEARCA:VNLA)
The actively managed fixed-income fund intends to offer returns above cash. Its investment objective is to provide a steady income stream with low volatility and capital preservation across economic cycles. VNLA is new in the market, having debuted in November 2016. It charges 35 bps in fees and has amassed about $40 million in assets so far.
The top three holdings of the fund are Westpac Banking Corporation FRN 11-JAN-2022 (2.25%), Rabobank Nederland FRN 10-JAN-2022 (2.25%) and Daimler Finance North America LLC FRN 06-JAN-2020 (2.26%). The product added about 0.2% on March 2.
Highland/iBoxx Senior Loan ETF (NASDAQ:SNLN)
Senior loans are issued by companies with below-investment grade credit ratings. In order to make up for this high risk, senior loans normally have higher yields. Since these securities are senior to other forms of debt or equity, they give protection to investors in any event of liquidation. As a result, default risk is low for such bonds, even after belonging to the junk bond space.
In a nutshell, a relatively high-yield opportunity coupled with protection from the looming rise in interest rates should help the fund perform better in the first half of 2017. SNLN could thus be a good pick for the upcoming days. The fund yields around 4.40% annually and charges 55 bps in fees.
Barclays Inverse U.S. Treasury Aggregate ETN (NASDAQ:TAPR)
Last but not the least, who can forget inverse bond ETFs in such a scenario? The product TAPR looks to track the sum of the returns of periodically rebalanced short positions in equal face values of each of the Treasury Futures contracts. It charges 43 bps in fees (see all Inverse Bond ETFs here).