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How To Use Leveraged ETFs To Beat The Fed

October 13, 2015 7:15 am
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Ten-year Treasury yields have declined 4.1 percent over the past month as market participants have continued adjusting to the Federal Reserve not raising interest rates following its September meeting.

Perhaps that explains why inflows to fixed income exchange traded funds have been so strong this month. Heading into Monday, three of October's top four asset-gathering ETFs were bond funds while just one bond fund was found among the month's 10 worst ETFs for outflows.

When it comes to how traders are viewing what that decision will be, Fed funds futures recently indicated that fewer than a third of fixed income traders are wagering the Fed will boost borrowing costs. However, there also is not a dearth of market observers that believe it is foregone conclusion the U.S. central bank will pass on raising rates.

Related Link: Playing A China Rebound With This ETF

For traders with an appetite for risk, there are some compelling ideas from the world of leveraged ETFs that could be worth considering as another Fed meeting nears.

Such wagers could be rewarded if Treasury yields start climbing again. Remember the erosive effects of rising Treasury yields (as bond yields rise, prices fall) on longer-dated bonds. A mere 1 percent increase in interest rates shaves more than 17 percent in value off a 30-year Treasury bond. An interest rate rise of 3 percent hammers Uncle Sam's 30-year bonds to the tune of 42 percent.

Such scenarios would be boons for the Direxion Daily 20+ Year Treasury Bear 3X ETF (NYSE: TMV), an ETF designed to deliver triple the daily inverse performance of the NYSE 20 Year Plus Treasury Bond Index (AXTWEN).

"Generally there are two approaches to consider in preparing for rates to rise. First, you can reallocate fixed-income holdings to other asset classes; investing in shorter-dated securities and shift to less rate-sensitive bonds. Some investors choose to implement a hedge–a more tactical approach to managing interest rate risk–instead of or in addition to restructuring," said Direxion in a new research piece.

Falling Yield

There is no such thing as a sure thing in financial markets, but it is a fairly sound assumption that if bond traders start pricing in an imminent rate hike, TMV will perform well. Conversely, if rates are destined to remain low and Treasury yields fall further to reflect that, there are some well-known leveraged equity plays that could thrive, including the Direxion Daily Gold Miners Index Bull 3X Shares (NYSE: NUGT).

All NUGT has done over the past month is gain more than 56 percent and traders have responded by plowing $420.1 million into the ETF this month. Gold benefits when rates remain low and inflation expectations rise. If those themes return in earnest, NUGT could surge.

"Tangible assets like gold tend to do well when rates are low and inflation is high. But when rates rise, investors tend to shift towards interest-bearing assets, with higher yields compared to gold. But on Friday (10/9), gold surged to a roughly six-week high the day after Fed minutes revealed caution about raising interest rates in the near term. Gold miners are inherently a leverage play on the metal. Miner stocks have been compressing for months now. But some investors think the sector may be setting up for a major multiyear move higher," said Direxion.

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