Friday’s ETF To Watch: U.S. Treasury Flattener ETN (FLAT)

by on August 26, 2011 | ETFs Mentioned:

Although the week got off to a pretty good start, yesterday saw markets slide once again as fears over European juggernaut Germany and their credit rating as well as the end of a short-selling ban on the continent overshadowed any residual optimism. This combined with unemployment claims that were still above 400,000 to suggest that the economy is still extremely shaky and is perilously close to falling back into recession at any time. Thanks to this uncertainty, today’s annual speech by Fed Chairman Ben Bernanke at Jackson Hole, Wyoming could be an extremely important event that sets the tone for markets for the foreseeable future.

In the speech, investors will be looking for the Chairman to, much like last year, ride to the markets’ rescue and hint at buying more U.S. Treasury debt in order to help push down yields. Yet, with yields on short-term debt already at all time lows and well below 0.3%, many are looking for the Fed to expand its balance sheet to longer term securities instead. This move could help to push down mortgage rates and possibly spur more housing investment while making other longer-term loans more affordable to consumers as well. Some feel that the Fed could also hint at lowering the interest rate it pays to banks on the excess reserves held at the Reserve. By doing this, the hope is that banks would be forced to lend more and that could potentially jump-start the economy and save us from the dreaded double-dip [See Five ETFs To Watch Ahead Of Ben Bernanke's Speech].

Nevertheless, many remain skeptical of the Fed’s ability to intervene further in the marketplace and expand its balance sheet further. Three members of the FOMC voted against Bernanke’s decision to keep rates on hold until mid-2013 while political pressure may also be mounting, given the growing fears of inflation down the road. Furthermore, many forget that Bernanke and Co. have not even hinted at more easing measures and that the market has pretty much created this speculation out of thin air. As a result of this wishful thinking, markets could dive dramatically if more easing measures are not in the cards when Bernanke gives his speech later today.

Thanks to the variety of ways today’s speech could go, a number of ETPs are likely to be in focus and could be on the move today. One that could be especially impacted but has likely flown under many investors’ radars is the iPath U.S. Treasury Flattener ETN (FLAT). This note tracks the Barclays Capital U.S. Treasury 2 Year/10 Year Yield Curve Index (-100%) which seeks to capture returns that are potentially available from a “steepening” or “flattening”, as applicable, of the U.S. Treasury yield curve. This is done through a notional rolling investment in U.S. Treasury note futures contracts with a ‘long’ position in Two Year futures and a corresponding ‘short’ position in 10 Year Treasury futures. In essence, this means that investors would gain if yields increased on the short term debt while simultaneously falling on the medium term issues [see all the Treasury ETFs here].

With this focus, FLAT could benefit greatly if Bernanke announces that a move to longer-term notes will be on the horizon. This would help to keep short-term rates stable but push down longer term ones, thus making the Treasury curve ‘flat’ and benefiting the holders of this iPath ETN. If, however, no plans to bring down longer-term rates are revealed, investors could see this product remain stable as investors will probably push into Treasurys across the board. If this happens, investors are likely to see FLAT underperform other Treasury products, suggesting that for those who are skeptical of more easing, this may not be the fund to look at during today’s trading session. With that being said, the curve has certainly become more flat over the past few trading sessions as FLAT has gained close to 13% in the past quarter and 9.4% in the past month alone, suggesting that a ‘flattening’ yield curve is becoming an increasingly popular trade for a variety of investors [see fundamentals of FLAT here].

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Disclosure: No positions at time of writing.