IEF: Why 7-10yr Treasury ETF Is A Compelling Buy During Fed Rate Cut Cycle

Summary

• The Federal Reserve stunned the world with an emergency rate cut of 50bps, the biggest single cut since late 2008.
• The yield curve looks set to bull steepen with the Fed most likely cutting further in the near future.
• While gains are expected in Treasuries ETFs across the board, we anticipate iShares 7-10yr Treasury ETF (IEF) to outperform on a risk-adjusted basis.

Fed Chair Jerome Powell followed through on his pledge last week to act as appropriate with a "shock-and-awe" emergency rate cut of 50bps, which was the largest since the Great Financial Crisis. As Bloomberg pointed out:

The surprise wasn’t necessarily the magnitude of the move. Rather, the shock is just how decisively the Fed chose to respond after signaling little urgency just a few days ago.

Indeed, the Fed's decision to take action now instead of the regularly scheduled FOMC meeting underscores their determination to prevent the recent stock market correction to spillover into a financial contagion. It can also be a prelude to the beginning of a new rate cut cycle. if we recall then-Fed Chair Ben Bernanke likewise surprised the world in August 2007 with a sudden discount rate cut of 50bps:

The Federal Reserve, reacting to concerns about the subprime lending crisis that's rocked financial markets in recent weeks, Friday cut its so-called discount rate half a percentage point, to 5.75 percent. -- August 17 2007 Source: CNN

Yield Curve Is About to Bull Steepen

What strikes resemblance between now and then is the fact that the yield curve had also just re-inverted based on the 10yr-1mo Treasury yield spread prior to the Fed's preemptive move:

Source: U.S. Department of The Treasury , WingCapital Investments

That proved to be the beginning of Fed's easing cycle, starting with September 2007's 50bp cut, which would not end until late 2008 at the peak of the Great Financial Crisis. In terms of the implications on the Treasury bond market, we observe how the shape of the yield curve evolved during the course of the cycle:

Source: U.S. Department of The Treasury, WingCapital Investments

In short, the yield curve shift can be summed up in the following 3 stages:

1. It was still slightly upward sloping prior to the market turmoil in the summer of 2007 (red)
2. The yield curve inverted and the Fed pulled the trigger in August 2007 (yellow)
3. With the rate cut cycle in progress, yield curve bull steepened with short-end Treasury yields dropping faster than the long-end. (blue)

Another example is the 2000 dot-com bubble burst, during which the yield curve similarly went through the above 3 stages as the Fed embarked on a series of rate cuts.

Source: U.S. Department of The Treasury, WingCapital Investments

Back to today, heading into the new decade, the yield curve was at the 1st stage when the pause in U.S.-China trade war led to brief steepening of the curve. Then, the economic optimism unraveled in light of the spiraling coronavirus outbreak, as the yield curve flattened and re-inverted last week with the collapse in stock market.

Source: U.S. Department of The Treasury, WingCapital Investments

Now that the Fed has acted with urgency, as history suggests more is still to come, we look set to enter the 3rd stage of the yield curve shift. To wit from WSJ:

Since 1998, the Fed has cut interest rates six other times between regularly scheduled meetings. Following each of those moves, the Fed has lowered rates again at its next policy meeting.

More Upside Ahead in Treasury ETFs & Why IEF Stands Out

With bond yields most likely a one-way street south in the foreseeable future, more gains are to be expected in Treasuries and their corresponding ETFs. A quick comparison of the Treasury ETFs, due to the massive flattening of the curve, it is without surprise that the long-end ETF (TLT) has been the clear-cut outperformer:

Treasury ETF Return Comparison	SHV	SHY	NASDAQ:IEF	TLT
Tenor	0 - 1 Yr	1-3 Yr	7-10 Yr	20-30 Yr
1-mo	0.40%	1.38%	4.55%	7.88%
YTD	0.54%	1.83%	7.46%	14.52%
1-year	2.46%	4.97%	15.96%	32.21%

Click to enlarge

As of 3/4/2020

However, with the yield curve headed for a bull steepening phase going forward, we expect the intermediate-end Treasury ETF (IEF) to be the next to shine. Looking back during 2007-2008, we notice that IEF and TLT both enjoyed double-digit return and were toe-to-toe over the course of the Fed's rate cut cycle:

Source: WingCapital Investments

Why We Prefer IEF over TLT

Although IEF ultimately only outperformed TLT by a few ticks between 2007-2008, IEF was actually a more favorable investment on a risk-adjusted basis. Specifically, due to the long duration profile of TLT, the volatility is persistently higher for the long-end ETF by more than 2x vs. IEF:

As such, when compared using a risk-adjusted performance metric such as Sharpe ratio, IEF would be superior relative to TLT if their total return ends up around the same. Meanwhile, in the scenario that the Fed overreacts and economic growth picks up quicker than expected, TLT could actually end up in the negative like in 2009, 2013 or 2015, during which TLT also underperformed IEF as well.

Total Return BY Year	IEF	TLT
2003	6.13%	2.86%
2004	4.97%	10.10%
2005	2.61%	8.56%
2006	2.58%	0.79%
2007	12.01%	12.14%
2008	14.44%	28.45%
2009	-5.06%	-19.81%
2010	9.27%	9.03%
2011	15.75%	34.03%
2012	2.90%	0.38%
2013	-4.90%	-11.08%
2014	9.26%	28.33%
2015	0.99%	-2.87%
2016	1.00%	1.17%
2017	2.55%	9.18%
2018	1.18%	-1.13%
2019	9.05%	16.61%

Click to enlarge

To summarize, while both TLT and IEF are expected to continue their march higher on ever lower interest rates, risk-reward favors the latter when the yield curve undergoes a bull steepening phase. In the event that the Covid-19 epidemic subsides quickly, the Fed most likely will remain their easing stance especially in an election year, and allow growth and inflation to overshoot to the upside, which would lead to sell-off in the long-end while the short-end remains stable. All in all, taking into account of price volatility and risks, we anticipate IEF to outperform in both economically bullish and bearish scenarios.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.

We may have options, futures or derivative positions in the above tickers mentioned.

Comments

[jasonbrand]

Too late a recommendation. It was obvious two months ago that (a) rates were already going down, and (b) the Fed was going to cut rates this year.

[WingCapital Investments]

If we recommended buying German 10-year bonds 5 years ago , we probably would be deemed as late. Or similarly when AAPL was at 100. The investment landscape is always changing so we would rather look forward than dwell on missed opportunities or hindsight.