Using Leveraged ETFs As Rising Rates Plays

Turn on CNBC or read news on financial web site or blog and chances are you'll something about how dismal oil prices and energy equities are performing. The Energy Select Sector SPDR ETF XLE confirms as much with a 19 percent year-to-date decline, by far the worst showing among the nine original sector SPDR exchange traded funds.

The Organization of Petroleum Exporting Countries (OPEC) refuses to cut production, a strategy that has helped the United States Oil Fund USO to a 44.1 percent year-to-date loss. Even with that, investors keep pouring money into USO and XLE.

Clearly, investments in USO have been the ultimate good money after bad trade, but that also sets oil up to be, perhaps, the ultimate near-term contrarian trade. With money managers and other professionals barely willing to nibble at oil from the long side, there is little in the way of institutional support for energy stocks and ETFs.

With interest rates poised to rise this month and perhaps several more times next year, it is not unreasonable to expect more downside for energy stocks and potential upside for an ETF such as the Direxion Daily Energy Bear 3X Shares ERY. ERY attempts to deliver triple the daily inverse performance of the index XLE tracks.

“Investors use energy stocks as somewhat of a proxy for owning oil or natural gas. With oil at its lowest levels since 2008, stocks in the sector are appealing to some value investors because they are beaten down. In fact, the price of oil and gas may remain beaten down in a high-interest rate environment. Higher rates raise consumer and business costs, which may reduce their amount of driving, lowers demand for oil, which keeps prices low,” said Direxion in a recent note. 

ERY entered Thursday as Direxion's second-best leveraged bearish fund on a month-to-date basis, although traders have pulled money from the fund over the past month, according to issuer data. 

Interestingly, energy stocks actually perform well in the wake of higher interest rates. In fact, XLE was the best of the nine SPDRs during the Fed's 2004 through 2006 tightening cycle. If history repeats, that could bring some much needed relief for the Direxion Daily Energy Bull 3X Shares ERX. 

“Oil prices are already at seven-year lows. World demand is down due to weakness in China and Europe, and Iranian crude has yet to add to the flood of black gold. But factors such as hurricanes, geopolitical conflict, a change in output from OPEC, and changes in domestic oil production can have counter effects on oil prices, even when rates rise. Just when you think you have oil prices figured out, a new factor can come into play. Even the fear of occurrences such as natural disasters and wars can cause oil prices to spike just when they should be dropping,” adds Direxion.

Put simply, those that are long ERX and XLE need to see the likes of Exxon Mobil Corp. XOM, Chevron Corp. CVX and Kinder Morgan Inc. KMI rebound as those names combine for about 30 percent of XLE's weight.