SHY: Short-Term Treasuries Can Keep Moving Higher

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About: iShares 1-3 Year Treasury Bond ETF (SHY)
by: Sankalp Soni
Summary

The SHY ETF has rallied by about 1% since November 2018, and is likely to keep moving higher.

The economic outlook continues to remain dull, which is inhibiting the Fed from tightening further.

The probabilities of a rate hike are falling, and chances of rate cuts are increasing.

The iShares 1-3 Year Treasury Bond ETF (SHY) is up 1% since November 2018 (capital gains on treasury related securities are usually relative small). The ETF currently also has a yield of 1.72%. While its price performance had been under pressure last year amid a hawkish Fed, the ETF has been turning around amid an increasingly dovish Fed, which is pushing yields lower, and short-term treasury prices higher. In fact, this trend is likely to continue going forward this year.

Source: Yahoo Finance

Prospectus Review:

The SHY ETF has an objective to provide investors with exposure to the ‘front end’ of the yield curve, by tracking the ICE U.S. Treasury 1-3 Year Bond Index. More specifically, the fund holds US treasuries with maturities between one year and 3 years. This makes the ETF a good investment/ trading vehicle for those who are want to bet on near term interest rate decisions by the US Federal Reserve.

The top 10 holdings of the fund include:

Source: ishares.com

Risk Note from SHY prospectus:

There is no guarantee that the Fund’s investment results will have a high degree of correlation to those of the Underlying Index or that the Fund will achieve its investment objective. Market disruptions and regulatory restrictions could have an adverse effect on the Fund’s ability to adjust its exposure to the required levels in order to track the underlying index.

The data below from ishares website reflects the tracking differences between the SHY ETF and the underlying benchmark:

Source: ishares.com

The reason I have chosen this ETF is because its strategy involves offering exposure to shorter-term bonds only that are likely to react sensitively to near term interest rate moves by the Fed. Given that the Fed’s near term moves are highly followed at the moment in anticipation of more dovishness, I believe this is a very interesting ETF to keep on the radar. The fund’s holdings only include bonds with maturities between 1 and 3 years, and thereby making it a good investment/trading vehicle for those who want to bet on the front end of the yield curve only.

Moreover, out of all the ETF’s that offer exposure to short-term treasuries, this ETF has the highest Assets Under Management (AUM), currently standing at around $18 billion, according to data from ETFdb.com. I consider AUM as a good indicator for how successful the fund has been in implementing its strategy to deliver on its objectives for investors. The higher its AUM, the more investors have allocated their capital towards the fund due to effective management. Moreover, it also has one of the highest average daily trading volumes, currently at 2.8 million. Hence this means that the ETF has a relatively healthy level of liquidity. This is a good indicator for how easily investors can buy and sell shares in the ETF. Therefore, the higher the trading volume, the lower the liquidity risks.

Chances of rate cuts are rising

While a dovish Fed this year has helped push treasury yields lower, and consequently allowed inversely correlated bond prices to move higher, its accommodative guidance has done little to ease economic concerns. The spread between 2yr and 10yr still remains very narrow, at around 17 basis points. This is reflective of more economic sluggishness ahead.

In fact, the interest rate futures are currently anticipating rate cuts in less than a year’s time. CME’s FedWatch is placing a 24.1% chance of a rate cut in January 2020 (at time of writing), as fears of a potential recession are still present among market participants. As the probabilities of monetary policy easing next year increases, short-term treasury yields will continue sliding, and hence push bond prices and the SHY ETF higher.

More dovish Fed members amid economic weakness

The probabilities of rate cuts have been rising amid more and more economic data weakness. In fact, most recently, voting Fed member James Bullard has stated that he feels the current level of the fed funds rate may be suppressing inflation. He doesn’t feel that the current rate is ‘neutral’, but instead claims it is ‘restrictive’. Thus, if more and more Fed members agree with Bullard as economic conditions continue to weaken, then the Fed will undoubtedly not be fulfilling its two rate hike projections for this year. Moreover, we could even witness a rate cut instead this year, with the probability of easing in December at 17.9%.

Furthermore, the global economy continues to slow. While China has been a persistent concern, most recently, the European Commission has lowered growth projections for 2019 from 1.9% to 1.3% for Europe. Moreover, the Bank of England has stated that there is a 25% chance of a recession in the UK this year, as the outlook becomes more and more worrisome. Hence, with the global economy is slowing, the US economy will certainly be slowing down as well.

Powell certainly mentioned the global economic slowdown as one of the “cross-current” issues facing the US economy, and with conditions only getting worse, it seems unlikely the Fed will be able to continue tightening much further this year. Therefore, short-term yields are most likely to continue moving lower, which will help support Treasury bond prices higher, and consequently the SHY ETF.

Strategy

Following dismal price performance for the SHY ETF last year, it is likely to perform much more strongly this year, as the Fed turns more and more dovish amid continuously weakening economic conditions. In fact, not only are the chances of rate hikes falling, but the probabilities of rate cuts are increasing, which will push yields lower, and allow the SHY ETF to rally higher. I recommend taking advantages of any dips in the ETF as buying opportunities, as the predominant trend is likely to be upwards for the ETF.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SHY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.