Are You Prepared for What the End of QE Will Do to Bond Prices?

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Equities rallied and bond prices fell through January as investors, relieved that Congress had avoided the fiscal cliff and postponed a fight over the debt ceiling, changed their stance to take on more risk.

With the immediate crisis over, the need for safe-haven instruments such as U.S. Treasury bonds has diminished, sending yield-starved investors scrambling for better returns.

Improving sentiment in the United States, Europe and even in Japan has sent U.S. Treasury bond prices lower. The yield on the 10-year Treasury bond is now over 2.0% for the first time since April of last year, having averaged 1.80% for 2012.

But it's not just improved sentiment that's going to push down bond prices.

How the End of QE Will Affect Bond Prices

U.S. Federal Reserve's quantitative easing (QE) policy has made a conservative buy-and-hold strategy in U.S. Treasury bonds very risky.

So risky, in fact, that a recent report by Charlie Gasparino of FOX Business Network states that UBS is planning to send a letter to its brokerage clients telling them that they have been reclassified as "aggressive" investors.

The letter, which is said to be controversial within the firm, is thought to reflect UBS's long-term bearishness on bonds.

In the meantime, conservative bond investors willing to sacrifice yield for the preservation of capital will suddenly find themselves classified in the same group as wild-eyed penny stock speculators and options cowboys. It is thought that UBS is reclassifying its customers to avoid future legal action when the bond market falls.

Even PIMCO's Bill Gross thinks the end of QE will pose major problems for the bond market. In his February briefing, Gross writes that the continual expansion of credit by the Fed and other central banks results in less and less real GDP growth.

"In the 1980s, it took four dollars of new credit to generate $1 of real GDP," Gross stated. "Over the last decade, it has taken $10, and since 2006, $20 to produce the same result."

The Fed has been up front about the conditions that need to be met for it to end quantitative easing but has been less open about how it plans to carry out the policy shift.

This has raised concerns not only among investors but, according to a report by noted Fed watcher Stephen Beckner writing for Market News International, among Fed officials themselves.

"Instead of raising short-term interest rates once economic recovery has been convincingly established and unemployment is falling, the FOMC has explicitly said it will delay hiking the federal funds rate "for a considerable time after the asset purchase program ends and the economic recovery strengthens,'" Beckner writes.

"Together, the Fed's open-ended, "flexible" asset purchases to hold down long-term rates and its plan to hold short-term rates down much longer make for an unprecedented experiment in monetary expansionism," Beckner continued. "When the phase-out of QE3 begins, bond yields and rates all along the maturity spectrum are sure to rise, even though the FOMC vows it will continue to hold the funds rate near zero for quite some time."

How to Profit from Lower Bond Prices

However you look at it, with the end of QE looming, U.S. Treasury bonds are not the safe haven they once were and investors should be prepared for that.

There are a number of ETFs that trade inversely to bond yields that could provide a hedge to an existing bond portfolio or an opportunity to profit from a decline in bond prices.

Some of the more liquid alternatives include the ProShares Short 7-10-Year Treasury ETF (NYSE: TBX), which trades inversely to the 7-year to 10-year U.S. Treasury bond market. Further out on the yield curve is the ProShares Short 20+ Year Treasury ETF (NYSE: TBT), which trades inversely to the 20-year to 30-year U.S. Treasury bond market.

Investors can find a leveraged way to short U.S. Treasury bonds with the Direxion Daily 20+ Year Treasury Bear 3x ETF (NYSE: TMV).

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