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PFIX: The Right Interest Rate Hedge Ahead Of The Fed's Rate Hike

Interest rates have moved steadily higher throughout 2022. It's time to hedge ahead of the next Fed move.

Fixed income investors continue to get blitzed as the Fed maintains its aggressive monetary tightening program. That's expected to take its next step this week when the central bank lifts the target Fed Funds rate by another 75 basis points, although a larger 100 basis point hike appears to be on the table as well.

That's meant a steady climb for interest rates all along the curve. Short-term yields have been particularly vulnerable. The 2-year Treasury yield, which is often considered a good proxy for Fed activity, is nearing the 4% level, a mark it hasn't reached since the financial crisis.

2-Year Treasury Yield

2-Year Treasury Yield

The rising rate environment is probably not over either. The Fed Funds rate is probably moving at least another 100 basis points higher even after this week's rate hike. Long-term Treasuries, which under normal circumstances respond more closely to economic conditions, are still pricing in Fed rate hikes instead. Treasury yields are not directly correlated with movements in the Fed Funds rate, but don't be surprised if they have a lot higher to go as well.

Time To Consider Interest Rate Hedges

If you haven't already, it's time to consider adding a rate hedge to your portfolio. I'm not talking about gold or TIPS or commodities. I'm talking about a literal interest rate hedge.

The Simplify Interest Rate Hedge ETF (PFIX) is simple in its strategy. According to the fund's website, it "holds a large position in over-the-counter (OTC) interest rate options intended to provide a direct and transparent convex exposure to large upward moves in interest rates and interest rate volatility." It's effectively a similar strategy to shorting long-term Treasury bonds, but uses a derivative probably less than intuitive to most retail investors and offers it to investors in a nice, neat ETF wrapper.

Simplify Interest Rate Hedge ETF (PFIX)

Simplify Interest Rate Hedge ETF (PFIX)

Since the beginning of the year, the 10-year Treasury yield has risen from around 1.6% to its current level just above 3.5%. That makes strategies that benefit from rising interest rates among the best and steadiest performers. In 2022, PFIX is the 3rd best-performing non-leveraged ETF, gaining nearly 70%. The only two funds it trails invest directly in natural gas futures contracts.

Investors have taken notice too. Over the past year, total assets under management have grown from $100 million to more than $320 million.

How To Use PFIX In Your Portfolio

Because interest rates tend to rise as inflation rises, PFIX can be used as an indirect inflation hedge as well. There's a chance that PFIX will actually work better as an inflation hedge than many ETFs that are specifically geared towards inflation hedging.

Take TIPS, for example. Their yields have certainly risen this year as inflation has risen, but they've also been a victim of the bear market in Treasuries. The -10% year-to-date return of the iShares TIPS Bond ETF (TIP) is only modestly better than the -12% return of the broader government bond market. I doubt that'll be much solace to investors.

ETFs that have focused on inflation-resistant sectors or securities have likewise had a rough go. Healthcare and financials tend to fit this bill, but they've had mixed results at best. Commodities-focused funds are another option, but they're highly volatile although the Invesco DB Commodity Tracking ETF (DBC) is up about 20%. PFIX may, however, be the most highly correlated asset to interest rate and inflationary pressures.

Outlook For PFIX In 2022

The bond market is acting as if the Fed will continue raising rates aggressively with no firm end date in sight. As long as that's the case, rates will probably keep drifting higher, which will be a good thing for PFIX.

The big question is when the rise will end. As soon as we get a hint that the rate hiking cycle is ending or inflation is decelerating in a more convincing fashion, it'll be the time to abandon PFIX. Those are both conditions that are likely to send interest rates falling again. A recession is another environment where interest rates tend to fall, usually significantly. In essence, the point in time where the Fed might have reason to pivot from hawkish to dovish (or even neutral) is the time to sell any position in PFIX.

But that time isn't yet. Rates will likely keep drifting higher through the end of the year before conditions have the potential of changing. As a short-term hedge heading into this week's Fed meeting, PFIX could be a good addition to your portfolio.

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