Embrace QE With These Three ETFs

by on November 1, 2010 | ETFs Mentioned:

As the economy continues to flat-line, many investors have forsaken investments in the United States for higher growing economies in emerging nations around the world. Growth levels in many of these countries continue to impress–in excess of 8% in some instances–and are attracting significant amounts of capital away from developed markets which have struggled to post solid growth levels above 2% a year or create any meaningful amount of jobs. With a rather dismal outlook, investors have turned to the Federal Reserve, which is widely expected to engage in a second round of quantitative easing (QE 2) in an attempt to shake the U.S. economy from its malaise.

The thought is that since near-zero interest rates were not enough to boost lending demand and liquidity, a program initiated by the Fed in order to boost the money supply and further drive down long-term rates might just do the trick. Economists say that this policy could lead to higher prices and inflation instead of the current near-deflationary environment and help spur the U.S. back to more solid levels of growth. This would hopefully be accomplished by having the Fed move in to buy vast quantities of U.S. government securities, mortgage backed bonds, or even stocks, thereby setting a floor underneath prices and theoretically boosting both market demand and confidence.

The move could also have a substantial impact on interest rates, despite the fact that the Fed funds rate is currently between zero and 25 basis points and rates are already at multi-decade lows. In fact, New York Fed President William Dudley said that a $500 billion asset purchase program would be roughly equivalent to a 0.5%-0.75% reduction in the Fed funds rate. This would represent a significant decline in real rates for the Treasury, consumers, or for businesses planning on using more capital to expand their operations. This cut could help to drive down the costs of borrowing which would have the effect of boosting incomes which could theoretically increase spending and send the economy higher [see Ten ETF Trends For The Next Ten Years].

You Can’t Fight It

While a number of economists and analysts believe that a QE program could be the cure for the sick American economy, some believe that the program will not offer any long-term benefits for the U.S. economy. The President of the Federal Reserve Bank in Kansas City, Thomas Hoenig, recently called more expansive monetary policy a “bargain with the devil,” noting that similar plans didn’t exactly boost Japan’s economy or help the U.S. the first time around. Despite these reservations and lack of historical evidence to back up the plan, it appears as if the market and many analysts have already priced in the launch of the second round of easing in the near future; investors might as well prepare for the inevitable money-printing by ‘Helicopter Ben’. In fact, a recent report suggests that the Fed will kick off this program by buying roughly $250 billion a month in bonds over the next three months [also see Why The European Bailout Is Just Postponing The Inevitable].

While this amount isn’t nearly as large as the program initially launched by the Fed in the heart of the financial crisis when Bernanke struck the markets with ‘shock and awe’ tactics, a quarter of a trillion dollars is still a substantial amount of money. And spending could possibly increase if this round of easing offers no material effect or if the economy continues to stagnate. This situation presents an interesting dilemma for investors who might not believe that the country will be able to grow significantly in the near term but would still like to benefit from any QE that the Fed launches in the weeks and months ahead. Below, we profile three ETFs that could be impacted as the Fed’s plans are put into effect.

iShares Barclays 20 Year Treasury Bond Fund (TLT)

One of the main targets of the Fed’s program is likely to be long-term Treasury bonds. These bonds are currently offering up yields in the neighborhood of 4% for thirty-year bonds, and a bond buying campaign by the Fed is likely to drive this number even lower. Unfortunately for the Fed, the market has steadily moved to shorter-term debt; by some estimates there is only $550 billion in outstanding Treasurys that have a remaining maturity of greater than 10 years. This suggests that any campaign by the Fed to buy up longer-term bonds will have an outsized impact on this comparably small market, which will likely help to drive down rates faster than most expect [see ETF Ideas For Deflation Defense].

TLT is by far the most widely traded ETF in the Government Bonds ETFdb Category, with over 7 million shares trading hands every day on assets of close to $3 billion. TLT tracks the long-term end of the government bond spectrum by following the Barclays Capital U.S. 20+ Year Treasury Bond Index, which measures the performance of U.S. Treasury securities that have a remaining maturity of at least 20 years. This focus on long-term debt–the weighted average maturity is 28 years–produces an effective duration of 15.5 years, suggesting that this fund will be among the most impacted by any interest rate changes that come about from a massive bond buying program by the Fed.

If the Fed moves to buy up medium-term debt due to its more widespread issuance instead, investors have a multitude of options to play this scenario. A popular choice that should perform well in this scenario is the iShares Barclays 7-10 Year Treasury Bond Fund (IEF). The fund has a relatively short effective duration when compared with its longer-term counterpart TLT; IEF comes in at just 7.30 years and posts a weighted average maturity of 8.7 years. However, the number of bonds that fall into this time horizon is far more extensive than what is available in the 20-30 year range and a reduction in these shorter term rates could help to drive down the costs of corporate borrowing more effectively, since many businesses and consumers deal with loans that are tied to these rate levels. For this reason, investors should also keep an eye on IEF if the Fed engages in a massive Treasury buying program [also read 2010: Year Of The Bond ETF].

iShares Barclays MBS Bond Fund (MBB)

A major area of speculation for the Fed’s program will be its foray into buying further amounts of mortgage backed securities. By some estimates the Fed has already bought more than $1 trillion of the MBS market, or roughly 20% of the total. Should the Fed further increase its purchases in the sector it could help to drive down rates in the market and possibly push up prices of already issued bonds. However, it remains to be seen if a small reduction in interest rates will help spur demand for mortgages given the lackluster economic situation and still declining home prices across much of the country [read Five Critical Questions To Ask When Investing In ETFs].

MBB tracks the Barclays Capital U.S. MBS Index which measures the performance of investment grade fixed-rate mortgage-backed pass-through securities of GNMA, FNMA, and FHLMC. Currently, the fund possesses over $2.2 billion in assets and has produced a return of 3.6% so far this year. However, the real focus of this fund is its yield, which is currently paying out 3.7% to investors. MBB has 71 holdings in total and has a heavy focus on short-term instruments; its average effective duration is just 1.6 years. Since a number of these bonds expire within the next 30 days– nine of the top ten holdings of MBB–look for the payout on MBB to drop rather quickly as it adjusts to the new interest rates [see Five High Yield Fixed Income ETF Options].

PowerShares DB USD Index Bearish Fund (UDN)

With a bloated Fed balance sheet to go along with the massive debts of the U.S. federal government, it is not unreasonable to assume that global investors will begin to lose confidence in the greenback and quicken their flight away from U.S. securities. In fact, some are beginning to worry that the Fed will be effectively monetizing the debt–which currently stands at $1.3 trillion–should Treasury purchases exceed $100 billion a month for a significant period of time. Such a scenario would call into question the fiscal health of the U.S. and perhaps further erode confidence in the dollar. If this initial round of easing does not produce the desired effect and the Fed is forced to print even more money to try to boost the economy, it could send the dollar back into the spiral we saw earlier this year [see the Top Performing Currency ETFs From The First Half Of The Year].

For investors concerned about a second round of QE and its impact on the dollar, UDN offers investors a chance to short the dollar against a basket of global currencies. This is accomplished by tracking the Deutsche Bank Short US Dollar Index (USDX) Futures Index, a rules-based benchmark composed solely of short USDX futures contracts. The USDX futures contract is designed to replicate the performance of being short the US Dollar against the following currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. Currently, the basket is heavily weighted with the euro (57.9%), Japanese yen (13.6%), British pound (11.9%), and Canadian dollar (9.1%).

The fund is not nearly as popular as its long-dollar counterpart UUP, which has amassed over $1 billion in assets, but UDN still has close to $185 million in assets and 300,000 shares trading hands on an average day. UDN has lost 1.2% so far in 2010 but over the past quarter the fund is up close to 5%. If the greenback continues to slide, UDN could see a significant surge in investor interest [also read The Definitive Guide To Short Dollar ETFs].

[For more ETF news make sure to sign up for our free ETF newsletter or try a free seven day trial of ETFdb Pro].

Disclosure: No positions at time of writing.