Could Rising Interest Rates Be Good for U.S. Treasury ETFs?

A rising interest rate environment could be difficult for some bond investors. Assuming everything else remains stagnant, when interest rates rise, bond prices tend to fall, and the opposite is true. Consequently, a bond exchange-traded fund (ETF) or bond portfolios could experience volatility when interest rates are moving. On February 14, 2017, U.S. Treasury ETFs, such as the iShares 20+ Year Treasury Bond ETF (TLT) fell due to Federal Reserve Chair Janet Yellen’s comments in her speech, indicating that the Federal Open Market Committee (FOMC) was open to interest rate hikes.

According to Fed Chair Yellen, “At our upcoming meetings, the Committee will evaluate whether employment and inflation are continuing to evolve in line with these expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.”

According to the CME Group FedWatch Tool, Yellen pushed up the probability of a Fed rate hike. Based on the CME Group 30-Day Fed Fund futures prices, the current probability of a 25 BPs rise in the FOMC meeting in March jumped to 26.6%, from 17.7%.

Trader Jason Bond said, “Although there is an increased probability of the Fed raising interest rates in its March meeting, the probability of a rate hike is still relatively low. Despite U.S. Treasury securities and U.S. Treasury yields having an inverse relationship, U.S. Treasury ETFs could rise over the long term if interest rates rise. It may sound counterintuitive, but fund managers are able to reinvest the cash flows received at a higher interest rate, which would increase income.”

Federal Reserve Could Raise Rates in March

Yellen stated, “Waiting too long to remove accommodation would be unwise,” when speaking to the Senate Banking Committee on February 14, 2017. The increasing economic growth and the market’s expectations of a potential increase in inflation has caused the Fed to leave the possibility of a rate hike on the table at its next meeting.

Now, in January 2017, U.S. Consumer Price Index was released, and U.S. consumer prices rose in December 2016, which was the largest YoY rise in two-and-a-half years. Moreover, on February 15, 2017, the U.S. Consumer Price Index increase by 0.6% in January, the largest increase in close to four years. This signaled that inflation pressures may be building.

Rate Hike Could Be Good For Treasury Funds

With strong economic data, and data suggesting inflation could be picking up, the Fed will not be able to ignore the strength in the U.S. economy and inflationary pressures. The Fed has an inflation target of 2%, and the current inflation rate is at 1.7%. If the Fed is proactive, it would not wait too long to raise rates, as Yellen stated in her speech.

That being said, some traders still believe that bond and U.S. Treasury funds could still rise over the long term, despite the potential rise in interest rates.

According to Director of Income Planning at the Schwab Center for Financial Research, “… a fund manager can react to rising rates by buying and selling bonds to try to maximize coupon income. For instance, a manager may sell lower-coupon bonds and use the proceeds to buy bonds with higher coupons, or may reinvest the income payments from individual bonds in higher-yielding bonds. Over time, that can actually boost the income you earn from a bond fund, meaning you can potentially recover from losses through increased returns.”

The Bottom Line

Federal Reserve Chair Yellen made some hawkish comments in her speech, on February 14, 2017, and it sent U.S. Treasury yields higher, and in turn, U.S. Treasury securities and Treasury ETFs fell. However, rate hikes could actually be good for Treasury funds because fund managers would be able to reinvest cash flows in bonds with higher yields.