ETF Spotlight: SHY's Future Gains Depend on Economy, Fed

The fund rose about 1% over the last month in anticipation of interest rate cuts.

The iShares 1-3 Year Treasury Bond ETF (SHY) was trading roughly flat less than 24 hours after the U.S. central bank sliced interest rates by 50 basis points (bps).

But SHY, which closely tracks the 2-year Treasury, is up about 1% over the past month as the likelihood of the first Federal Reserve rate cut in more than four years increased.

That increase is "huge for such a short-term bond ETF," said etf.com senior analyst Sumit Roy, although he added that "the gains from here won’t come so easy.

On Wednesday, the Fed slashed the federal funds rate—the target interest rate that commercial banks charge each other for lending their extra reserves overnight—to a range between 4.75% and 5%. The cut, the first in four years, arrived amid rising concerns about a jobs slowdown and potential recession. The bank had been previously focused on inflation, which has waned over the past year.

Roy noted that "the 2-year Treasury was last yielding 3.6%, which is well below" the new funds rate.

"In other words, it’s already pricing in a lot of Fed rate cuts," Roy said.

SHY: More Aggressive Rate Cuts

SHY, which has nearly $24 billion in assets under management and a 0.15% expense ratio, tracks a market weighted index of debt issued by the US Treasury with 1-3 years remaining to maturity. Treasury STRIPS are excluded. SHY is a leader in its segment that offers investors a stable, liquid product for buy-and-hold and more short-term strategies. The fund tracks the ICE US Treasury 1-3 Year Bond Index but avoids the index's more liquid components to keep costs down.

Roy said that for SHY to generate huge gains in the near future, asset markets will have "to start pricing in even more aggressive rate cuts."

That might be "reasonable if the economy continues to hum along," he said. "On the other hand, if economic data weakens and recession risks start to rise, SHY could rally further still."

The Fed is projecting a potential drop in the funds rate to around 4.4% by the end of this year and to approximately 3.5 by the close of 2025, although it also noted in a statement that "the economic outlook is uncertain."

Roy added: For investors looking just at yield, ultra-short-term bond ETFs and money market funds will offer higher rates than SHY given the premium in the fed funds rate versus 2-year Treasuries.