A year of debating and crystal-ball-gazing by the Federal Reserve has left traders in almost the exact same position as this time last year — with another December FOMC meeting to determine whether it’s time for our annual rate hike. More than a few strategists thought that the Fed would use the cover of Brexit and Trump versus Clinton to hold off on hiking rates in 2016, but with the Fed out of excuses after the election, will surviving a hike be as easy as dusting off the 2015 playbook?
History rarely ever repeats itself and this December’s meeting is taking place against a very different backdrop than last year’s. Markets have taken the one-off rate hike and visible dissension at every FOMC meeting as a sign that rates are once again frozen, which helped push the 10-year Treasury note yield down from 2.27% to 1.56% by the end of the Q3 while the two-year yield is down from 1.06% to just under 0.8%. The yield curve is 30% flatter than it was last December.
For bond traders, that falling yield curve meant it was almost impossible not to make money with bond exchange-traded funds (ETFs) in 2016. And with nearly all zero coupons positive through September, the only question was how much duration you were willing to take on. Consider the iShares 1-3 Year Treasury Bond ETF (SHY) up 1.27% and the uber-long term Vanguard Extended Duration Treasury ETF (EDV), up over 20.5%, as bookmarks. But now that the yield curve is at its flattest levels since 2007, traders can’t leave anything to chance.
If the thought of researching funds to target different points of the yield curve makes your head hurt, always remember someone created a fund to cure that, and this time, it’s the people at iPath Exchange Traded Notes that have a solution. In 2010, they created two funds to target shifts in the most common depiction of the yield curve, the difference between the 10- and two-year Treasuries, with the iPath U.S. Treasury Flattener ETN (FLAT) designed to profit from a flattening curve while its sister fund; the iPath U.S. Treasury Steepener ETN (STPP), well you get the idea (see “Playing the curve” below).
Make sure to visit their website if you want a better description of how their strategies work. Both funds have the same reference index, the Barclays U.S. Treasury 2Y/10Y Yield Curve Index, which consists of a long position in a two-year Treasury futures paired with a smaller short position in the 10-year futures; meaning the index should rise in the event of a steepening yield curve, and as you can imagine, it’s been a rough few years for STPP with the fund down more than 12.6% in 2016 through September while FLAT was up 4.7%.
Both funds carry high expense ratios of 0.75% and can be thinly traded resulting in high bid/ask spreads. But if you’re wondering why the returns for FLAT were so, well flat, compared to funds like the iShares Barclays 7-10 Year Treasury Bond Fund (IEF), that was up 7.2%, remember FLAT is a very different type of fund. IEF and EDV target specific points along the yield curve and profit when rates in that area fall while FLAT and STPP are meant to target shifts along the ENTIRE curve. And yes, the curve has been flattening, but it’s been flattening across the entire curve by nearly equal amounts, which means some of the gains from the long two-year position were eroded by shorting the 10-year rate.
So while FLAT might not offer the potential returns of EDV if the Fed stays its hand, it might offer a good balance for traders without a strong opinion on every point of the yield curve.