Are You Afraid Of Rising Interest Rates? Here’s A Possible Solution
Summary The yield curve is an important graph that offers key information about the economy. Given that investors in a bull market are afraid of rising interest rates, other opportunities are being looked at. The Steepener and Flattener ETNs offer opportunities to take advantage of an increase in interest rates. The Fed recently decided to keep interest rates flat. But I believe interest rates will not remain flat forever. Therefore, it is worth taking a look at how someone could protect themselves against the rise of interest rates in the future. This article will focus on the characteristics of the yield curve with an emphasis on the Steepener ETN (NASDAQ: STPP ) and the Flattener ETN (NASDAQ: FLAT ). ETNs are structured products that are issued as senior debt notes, while ETFs represent a stake in an underlying commodity. These two ETNs are perfect opportunities to protect any investor against rising interest rates, as this surge will have an adverse effect on the stock market (NASDAQ: QQQ ). The Yield Curve The yield curve is a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity. Here’s the current U.S. yield curve: (click to enlarge) Source: Treasury.gov . The short-term interest rates are administrated by the FOMC , while the long-term interest rates are created by the forces in the stock market. The Yield Curve Spread The yield curve spread is the yield differential between two different maturities of a fixed instrument. For example, the difference in yield between a two-year Treasury note and a 10-year Treasury note would create another line, a so-called spread. The later-maturity leg is considered a back leg and the leg that matures first is called the front leg . The spread between the two- and 10-year Treasury instruments has shown significant patterns over the last few decades, as seen here: Source: Forbes . The spread increases during bubbles, such as the tech bubble (1999-2001) and the mortgage crash (2007-09). This indicates that this strategy (taking advantage of the difference between the two- and 10-year yields) can be played out from time to time when equity markets might be under threat and heading toward a bear or bull market. This pattern is perfectly described below: (click to enlarge) Current times make things interesting, as interest rates are expected to increase in the future. This is a situation that has happened over and over again the last few decades: (click to enlarge) Source: Fed . As the graph above depicts, interest rates cycled upward and downward during the bull and bear periods of the economy. Yield Curve Strategies – Steepener and Flattener Source: Created by author. Flattener Strategy A flattening curve is a situation where the yields on the short-term and long-term dated treasuries are converging. In other words, they are coming closer together. From a bank perspective, this is not always considered favorable as banks borrow money at short-term rates while lending it out at long-term rates. When the yield curve converges, the short- and long-term yields come closer to each other and thus diminishing the profit for the bank. Yet, the steeper the yield curve gets, the higher the differential between long-term yields and short-term yields. That means more profit for a bank. When the yield curve becomes more flat, the iPath U.S Treasury Flattener ETN comes into play as it tracks the spread between the two-year and 10-year yields. One should not forget that these ETNs are leveraged, as a 0.1% move in the spread will indicate a 2% price change for FLAT . The flatter the yield curve gets, the better for the Flattener ETN. Steepener Strategy When the differences in yield in the short and long term are diverging (i.e., getting more steep), the iPath U.S. Treasury Steepener ETN is another option. The objective of this product is to hold a weighted long position in the two-year Treasury future and a weighted short position in the 10-year future, in contrast to the flattener. With a steepener you buy the spread, while with the flattener you sell the spread. They are opposites: Negative Rates As this article assumes rates will eventually go up, a potential scenario with negative rates — even though it has been deemed unlikely by Janet Yellen — should not be ignored. That’s because some economists believe the economy is still not growing as expected, and negative rates would basically indicate that anyone who wanted to borrow money would get paid. This would act as a potential strong stimulus to the economy. Even though it might appear to be an unlikely scenario at first, there are places in Europe that currently have negative rates in place, such as Switzerland. In the Fed’s projections, a negative Fed Funds rate was deemed plausible: Source : Fed . Summary Investors do not have to worry about a potential increase in interest rates as there are good investment vehicles to protect themselves against these potential rate hikes. As the yield curve has shown many predictable signs of explaining the economy , it’s important to keep an eye on how the yield curve develops over time. I currently do not hold positions in either ETN. However, both are on my watch list as I consider them splendid investment opportunities for when the equity markets dwindle lower or when the Fed finally decides to start increasing the Fed rate. Liquidity is a minor issue with both ETNs, but when interest rates eventually increase I expect liquidity to increase as well. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.