Since the beginning of the year, bond prices have been rising and rates have been falling—that is the natural relationship between bond prices and their yields. When prices rise, rates fall, and when prices fall, rates go up.
The Federal Reserve has had a big hand in the prices rising for the first half of the year, as they have been active in their open market operations in order to keep interest rates low. There was also their involvement in the mortgage-backed market, which was dubbed QE III, or quantitative easing three. By being active buyers in the treasury market as well as the mortgage market, they were able to keep interest rates down.
Now, interest rates could be undergoing a major move, and I want you to profit from that move. Here is how:
The reason for the Fed’s buying was to keep the economy moving in the right direction. For the most part this strategy has worked as the economy has been growing and the job growth has shown tremendous improvement over the last five years. I say “for the most part” because the first quarter of this year showed a contraction of 2.9% in the US GDP. Rightly or wrongly, most of the decline was blamed on a particularly brutal winter in the northern half of the country.
Flash ahead to the current situation and we have more information. First, the Federal Open Market Committee has announced a plan for tapering off their bond purchases, especially the mortgage-backed securities purchases. The plan calls for a gradual tapering of $10 billion less in purchases per month, which means the mortgage-backed purchases would come to an end in September—that is if they stick to the plan.
The Fed is scheduled to meet again this week and there will be a rate decision today, July 30. No one expects the FOMC to change the rates, but the comments that accompany the rate decision will certainly have an impact on bond trading as well as the stock market.
Personally, I think interest rates are getting ready to rise. Large Speculators have been bearish for almost a year now based on the Commitment of Traders Report for the 10-year Treasury Note. The Fed is scheduled to end their mortgage purchasing in September, and the economy is expected to show growth of 3.2% when the advanced look at second quarter GDP is released as well.
So how do you make money off rising interest rates as an individual investor who doesn’t want to sell treasury futures short? As I explained earlier, when interest rates rise, the price of bonds fall. As with most things these days, there is an ETF for that. The ProShares UltraShort 20+Year Treasury fund (TBT) is designed as an inverse ETF for long-term treasury bonds and notes. When the price of treasury bonds fall, the TBT should rise.
Looking at the chart of the TBT, we see that the fund is hovering near two different support levels. The lows from November 2012 and April 2013 were $58.36 and $58.23 respectively. The low from the past two and a half years is $56.32, and that came in July 2012. We also see on the chart how the fund rallied sharply last spring, moving from the $60 area to as high as $82.80 in four short months. That is a 38% jump in four months.
The economy is growing and the employment picture is improving. These are the biggest reasons that make me believe interest rates are getting ready to rise. The fact that the FOMC has already announced their plans to taper QE III adds fuel to the fire, and then there is the sentiment toward bonds being bearish for almost a year.