Fed Preparation With Currency Hedged ETFs

Ten-year Treasury yields have climbed 10.1 percent over the past month as market participants continue pricing in higher odds of the Federal Reserve boosting interest rates next month. Predictably, the PowerShares DB US Dollar Index Bullish Fund UUP, the U.S. Dollar Index tracking ETF, has jumped 5.4 percent over the same period.

Also predictably, the dollar's rise at the hands of soaring Treasury yields could stoke more inflows to one the fastest-growing segments of the ETF market: Currency hedged funds. Widely documented is the fact that investors have poured so much cash into currency hedged ETFs this year that 2015's top two asset-gathering ETFs are currency hedged funds and issuers are rushing to bring more of these products to market.

And some of these funds prove successful right away. For example, the iShares Currency Hedged MSCI Eurozone ETF HEZU is just 16 months and already has more than $1.8 billion in assets under management. HEZU's EAFE counterpart, the iShares Currency Hedged MSCI EAFE ETF HEFA two months away from its second anniversary and has more than $3 billion in assets under management.

In the current environment of bifurcated of developed market central bank monetary policy, it is not a stretch to say those AUM totals will rise with some assistance from the Fed.

"Looking forward, we will likely continue to see a divergence between U.S. and international short-term rates as central banks in these regions maintain easy money while the Fed tightens. This rate divergence helps explain the renewed strength in the U.S. dollar, which last week reached its highest level since the spring, as Bloomberg data show," said BlackRock Global Chief Investment Strategist Russ Koesterich in a recent note.

HEZU, which allocates 61 percent of its combined weight to French and German stocks, is an ETF to keep an eye in the near-term as the Fed mulls higher interest rates at the same time the European Central Bank considers expanding its already substantial quantitative easing regime.

"I continue to like international developed markets, such as Europe and Japan. However, a strong dollar can erode the local gains made in international stocks. As such, given my expectation for further dollar appreciation, I believe investors should use vehicles that hedge most or all of their international currency exposure," adds Koesterich.

HEFA should not be ignored, either. The ETF allocates over 29 of its combined weight to Eurozone nations and 23.1 percent to Japanese stocks. With Japan, Asia's second-largest economy technically in recession, the Bank of Japan might be forced to consider expanded monetary stimulus. Australia, a country that has not shied away from slashing interest rates, accounts for 6.2 percent of HEFA's weight.

A wild card for HEFA is the ETF's 19.3 percent weight to the U.K. because the Bank of England could raise rates while rival central banks in Europe go the other way.