Treasury seeking: short US Treasuries using ETFs

Loren Norton at Direxion looks at the opportunity to short US Treasuries using ETFs

Over the last 10 years, the yield on the US Treasury two-year note has exhibited a high correlation to the targeted Federal funds rate. Although past performance is not indicative of future results, if this correlation continues the two-year note offers investors a proxy for the Federal funds rate, which is typically difficult to trade as an average investor. At some point, the expansion in the global economy is likely to predicate an increase in this rate, to combat inflationary pressures. 

If the correlation between the two year and the Federal funds rate holds, much like it did in 2003-2006 when the Federal Reserve raised rates a record 17 times in succession, investors may have a real opportunity to exploit a structural trade in the yield curve of US Treasuries by shorting the two-year US Treasury note. Depending on how aggressive the next Federal tightening cycle is, there could also be substantial depreciation in other markets globally. 

For example, commodity markets face a serious headwind anytime the Fed is in a tightening cycle, which would have a negative effect on the commodity markets and the stocks of commodity companies in the equity market. An active Fed affects everyone and its next tightening cycle is unlikely to be an exception. So having a plan for rising short term interest rates is not only preparing for a potential scenario in the markets, but is preparing for an eventual scenario, the effects of which every investor should think about.

Shorting the Federal funds rate has always been difficult for market participants not active in the US repurchase agreement market or futures market.  In fact, it just recently became possible for retail investors to short the two-year treasury without access to the US repurchase agreement market. 

The recent release of bull and bear levered Treasury ETFs in the US allows investors to express a view on Treasuries in a way that uses less capital. If the historic volatility of the two-year is any indication of what its volatility is going to be like going forward, compounding issues frequently exhibited in levered ETFs on equity indices will not really be an issue because the relative volatility is much lower. 

This could make levered ETFs on short Treasuries a convenient, effective trading tool for hedging the Fed and its effect on the global markets. However, as with all investments on the short side, there is a cost associated with waiting for a short position to move in your favour.  

Scenario Analysis: Projected movements of the Federal funds rate and the two-year Treasury yield 

Consider the following three hypothetical examples of what might happen to the two-year Treasury note, assuming that the spread between the two-year note and the Federal funds rate remains constant.  These scenarios demonstrate projected hypothetical returns of a short position taken in the two-year Treasury, and a three times multiple of that return, over the next two years.  It is important to remember that they are not representative of any specific fund’s performance.  

Assumptions and methodology:

• There is perfect correlation between the Federal funds rate and the two-year Treasury yield. Historically, this number has been 0.94 as measured over the last 10 years.
• The performance of the two-year Treasury note assumes both percentage change in yield and coupon reinvestment. 
• The Libor rate is 23 basis points (bps) above the Federal funds rate. The spread between the two-year Treasury note coupon and Libor is 70 bps resulting in a total spread of 93 bps.
• Both the coupon and the Libor change on the date of change in the Federal funds rate, and remain unchanged between dates.
• The models assume a Repo rate of 10 bps below Libor.

What happens if the Federal funds rate starts to increase immediately?

In this scenario, our calculations assume 25 basis point monthly increases in the Federal funds rate as well as continued constant correlation of the two-year Treasury yield. Based on the hypothetical assumptions previously mentioned, a short position in the two-year Treasury is able to perform positively.

What happens if the Federal funds rate does not start to rise immediately?

In this scenario, our calculations assume 25 basis point monthly increases in the Federal funds rate as well as continued constant correlation of the two-year Treasury yield. Based on the hypothetical assumptions previously mentioned, a short position in the two-year Treasury is able to perform positively.

What about in the case in which the Federal funds rate remains unchanged for an extended period of time?

Given the current environment there is a cost of being short that offsets the potential for return that is generated from a decline in price of the note. In the instance that rates remain unchanged, it may not be the best decision to short the two-year Treasury note. For example, there could be a total return scenario in which rates on the two-year stay unchanged while the cost of being short is assessed through time.

While timing is critical in any short position, a brief survey of global markets during past Federal tightening cycles is a reminder that no matter what market you are in, finding a strategy that is likely to perform is difficult given the likely effects on asset values broadly. Based on the correlation between the yield on the two-year and the Federal funds rate at the start of the decade, shorting the two-year may be effective this time around when the seemingly inevitable turn in the Federal funds rate finally arrives.